contractarian theory and unilateral bylaw amendments · 2018. 6. 29. · the mbca allows the...

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Contractarian Theory and Unilateral Bylaw Amendments

Albert H. Choi and Geeyoung Min*

June 29, 2018

Forthcoming in Iowa Law Review

Abstract

Corporate directors have been utilizing a potent mechanism in dealing with shareholder activism and shareholder litigation: the right to unilaterally amend corporate bylaws. Directors have exercised this right, for instance, to impose various requirements on who can nominate a director or call a special shareholder meeting, or to designate an exclusive forum where the shareholders can bring suit. Based on the theory that corporate charters and bylaws constitute a “contract” between the shareholders and the corporation, courts have blessed many of the bylaws that directors have unilaterally adopted. This Article examines the contractarian theory by drawing a parallel between amending charters and bylaws on the one hand, and amending contracts on the other; and by comparing the right to unilaterally amend corporate bylaws with the right to unilaterally modify contracts. The Article shows how contract law imposes various limitations on the modifying party’s discretion. The Article also compares the standard contractual relationship with that of the shareholders and the corporation more generally and uncovers several important differences that could make shareholders (particularly, minority shareholders) more vulnerable to counterparty (directors’ and controlling shareholder’s) opportunism. For example, unlike contracting parties who have the right to terminate the contractual relationship or opt out of undesirable modifications, shareholders lack the right of termination or opt-out. As a possible solution, the Article considers various mechanisms, including giving the shareholders the right of optional redemption, more robust disclosure, the right to vote (including the right to elect or replace directors), and subjecting bylaw amendments to more active judicial oversight. The Article suggests that active judicial oversight, through the vigorous application of the proper and equitable purpose test or imposition of good faith and fair dealing obligations, would be better in retaining the desired flexibility and policing directors’ and controlling shareholder’s opportunism.

* Professor and Albert C. BeVier Research Professor of Law, University of Virginia Law School; and Adjunct Assistant Professor and Postdoctoral Fellow in Corporate Law and Governance, Columbia Law School, respectively. We would like to thank Rick Brooks, Quinn Curtis, Elisabeth de Fontenay, Zohar Goshen, Larry Hamermesh, Clara Hochleitner, Mike Klausner, Vice Chancellor Travis Laster, Alex Lee, Ann Lipton, Joshua Mitts, Peter Molk, Roberta Romano, Sarath Sanga, Matt Shapiro, David Skeel, Emily Stolzenberg, George Triantis, Fred Tung, workshop participants at the University of Virginia Law School, and conference participants at 2018 Corporate and Securities Law Conference at Tulane Law School for many helpful comments and suggestions. We would also like to thank MacLane Taggart (University of Virginia Law School, JD Class of 2019) and Wenxi Zhang (University of Pennsylvania Law School, JD Class of 2019) for excellent research assistance. Comments are welcome to [email protected] and [email protected].

Contractarian Theory and Bylaws June 29, 2018

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Introduction

Over roughly the past decade, corporate directors have been utilizing one of the most potent mechanisms in dealing with shareholder activism and shareholder litigation: the right to unilaterally amend corporate bylaws.1 While corporate governance arrangements can be tailored using either the charter or the bylaws,2 modifying the charter requires shareholder approval,3 which can be time-consuming, costly, and uncertain.4 On the other hand, directors can unilaterally amend the bylaws quickly, at a low cost, and with certainty: they can simply convene a board meeting and adopt a necessary resolution5 and bypass a shareholder vote.6 Directors have deployed this power on numerous occasions.

1 See Lawrence Hamermesh, Director Nominations, 39 Delaware Journal of Corporate Law 117 (2014) for examples of directors’ adopting advance notice bylaws in response to shareholder activism regarding director elections. See Albert Choi, Fee-Shifting and Shareholder Litigation, 104 Virginia Law Review 59 (2018) for a brief overview about the concerns over deal-related shareholder litigation, perceived to be “out of control,” and how that led corporations to adopt fee-shifting and exclusive forum bylaws. 2 There are exceptions, however. For instance, whether to have a super-majority voting, to allow the directors to issue certain stock without shareholder approval (“blank check preferred provision”), to exempt directors from personal liability for breach of duty of care, or to have cumulative voting must be contained in the charter. See Delaware General Corporation Law (“DGCL”) §§102(b)(4), 102(a)(4), 102(b)(7), and 214. A staggered (or classified) board provision, though can be in the bylaws, requires a shareholder approval. See DGCL §141(d). 3 See DGCL §242. See also the Model Business Corporation Act (“MBCA”) §10.03. Charter amendment is considered to be a “fundamental” change to the corporation, thereby triggering shareholder approval requirement. When a proposed charter amendment “adversely affects” a certain class of shareholders, that class will get to vote on the proposal as a separate class. See DGCL §242(b)(2). See also MBCA §10.03. For a more detailed analysis of charter amendments, including the requirements and procedures under the federal securities laws, see Geeyoung Min, Shareholder Voice in Corporate Charter Amendments 43 Journal of Corporation Law 289 (2018). For Delaware corporations, there is a small number of exceptions to the rule. Unless expressly prohibited by the charter, the directors can unilaterally change the name of the corporation, delete the names of the incorporators, or delete the provisions that were necessary to effect stock exchange, reclassification, etc., when such changes have become effective. See DGCL §241(b)(1). See also MBCA §10.05. 4 For a publicly traded company, the company will have to abide by the federal proxy regulation in securing shareholder approval. See Securities and Exchange Act §14(a) and Securities Regulation Section 14A. Also, influential proxy advisory firms, such as Institutional Shareholder Services and Glass Lewis, have the policy of giving negative recommendations at the next director election when a firm adopts a charter provision (materially) adverse to the interests of shareholders, such as staggering the board. See Min (2018) for a more detailed analysis. Notwithstanding this, there are instances where a charter amendment would be more advantageous, especially if the directors expect little or no shareholder resistance. Because they have the sole power to make an amendment proposal, under DGCL §242, they get to dictate the content and once the amendment has been adopted, shareholders will be unable to change it unilaterally. 5 See, e.g., DGCL §§141(b) and 141(f) (stipulating minimum quorum requirement for a board resolution and allowing resolution through written or electronic communication). See also DGCL §141(a) (granting broad authority to the board by stating that: “The business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided in this chapter or in its certificate of incorporation”). 6 The MBCA allows the directors to unilaterally amend bylaws while the Delaware General Corporation Law requires a charter to have a granting provision. See, e.g., MBCA §10.20 and DGCL §109. Almost all large, publicly traded corporations that are incorporated in Delaware have the express provision in their charters granting the right to amend bylaws to the directors. See Min (2018). When both the shareholders and the


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For example, many have attempted to better manage out-of-control shareholder litigation by requiring all shareholder lawsuits to be filed only in Delaware (“exclusive forum bylaw”),7 Similarly, some have adopted a bylaw that requires an activist shareholder to provide detailed information about itself and its director-nominees (“advance notice bylaw”) to better prepare for a potentially costly proxy fight.8 Other directors have shifted the corporation’s litigation expenses onto unsuccessful (or not fully successful) plaintiff-shareholders (“fee-shifting bylaw”).9 Even when they were adopting a bylaw provision in response to shareholders’ demands, because they could dictate the contents of the bylaws, directors could devise a system that is potentially more favorable to them, while still showing “fidelity” to shareholder wishes.10

These bylaw amendments, while facially dealing more with process and rules issues,11 can undoubtedly affect a shareholder’s substantive rights. But when shareholders challenged the bylaws in court, the courts have relied on the contractarian principle to uphold the amendments. The Delaware Supreme Court’s opinion in ATP Tour, Inc. v. Deutscher Tennis Bund12 is exemplary. While upholding a fee-shifting bylaw that the directors of ATP Tour, Inc. unilaterally adopted, the Court stated that the charter and bylaws constitute a “contract” between a corporation and its shareholders.13 The Court stated that the directors can amend the bylaws by adopting a fee-shifting provision because the ATP’s charter grants the directors that right.14. The Delaware Chancery Court applied similar reasoning when validating an exclusive forum bylaw in Boilermakers Local 154

directors have the right to unilaterally amend bylaws, it is not entirely clear whether the directors can unilaterally amend (or repeal) shareholder-adopted bylaws. The ambiguity stems from the fact that the statute expressly reserves the right of the shareholders to amend bylaws without consent or approval by the directors. See infra part I for more detailed discussion. 7 See Choi (2018) and Jill Fisch, The New Governance and the Challenge of Litigation Bylaws, 81 Brooklyn Law Review 1637 (2016). 8 See Hamermesh (2014) for a detailed analysis and examples of recently contested advanced notice bylaws 9 Greatly alarmed by this development, the Delaware legislature amended the corporate statute to prohibit any fee-shifting mechanisms either in the bylaws or the charter. See Choi (2018) (Fee-Shifting). See infra Part I-B for an overview of recently contested bylaws. 10 This is the idea behind the “compromised implementation,” as noted in Min (2018), where the directors, putatively in response to shareholders’ (often repeated) requests to institute a certain corporate governance regime, would adopt a bylaw provision but with variation (or “compromise”). 11 See Gow v. Consol. Coppermines Corp., 165 A. 136, 140—142 (Del. Ch. 1933) (stating that “as the [certificate of incorporation] is an instrument in which the broad and general aspects of the corporate entity’s existence and nature are defined, so the by-laws are generally regarded as the proper place for the self-imposed rules and regulations deemed expedient for its convenient function to be laid down”). See also Hollinger Int’l, Inc. v. Black, 844 A.2d 1022, 1078 (Del. Ch. 2004) (Citing Gow and stating that “traditionally, the bylaws have been the corporate instrument used to set forth the rules by which the corporate board conducts its business”). 12 91 A.3d 554 (Del. 2014). 13 According to the Court, “corporate bylaws are ‘contracts among a corporation’s shareholders’…” Id. at 558. Due partly to concern over chilling, even legitimate shareholder lawsuits, the Delaware Legislature will later amend the corporate statute and prohibit fee-shifting provisions from being included either in the charter or the bylaws. See DGCL §§109(b) and 115. See infra Part I for more detailed analysis. 14 91 A.3d 554 (Del. 2014) at 560.


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Retirement Fund v. Chevron Corp.15 The court stated that “the bylaws constitute a binding part of the contract between a Delaware corporation and its stockholders,”16 and when the right to amend the bylaws has been granted to the directors the shareholders “will be bound by bylaws adopted unilaterally by their boards.”17

To be accurate, the ATP Tour and Boilermakers courts did not state that the shareholders are stuck with the director-adopted bylaws. The Boilermakers court emphasized the fact that if the shareholders are displeased with the adopted bylaw provision, instead of challenging the provision’s validity in court, they can either repeal the bylaw, adopt their own bylaw, or even remove directors from the board (probably in the next election cycle).18 Yet, the court imposed little restriction on the director’s right to amend bylaws except perhaps, where there is “fraud, undue influence, or overweening bargaining power.”19 In short, the court seems to indicate that the proper venue for working out disagreements and resolving agency issues is in the board room and not the court room.

15 73 A.3d 934 (Del. Ch. 2013). After the decision, there was even a debate about whether the directors can adopt a mandatory arbitration provision in the bylaws. See Claudia Allen, Bylaws Mandating Arbitration of Shareholder Disputes?, 39 Delaware Journal of Corporate Law 751 (2015) and Lipton (2016) (analyzing the issues over mandatory arbitration clause in charters or bylaws and the problems of treating charters and bylaws literally as contracts). The issue over mandatory arbitration bylaws became moot when the Delaware Legislature amended the corporate statutes to allow forum selection clauses which designate Delaware but not other forums, including arbitration. See DGCL §115. See also David Skeel, The Bylaw Puzzle in Delaware Corporate Law, 72 Business Lawyer 1 (2016) (arguing that the Delaware legislature’s decision to uphold an exclusive forum bylaw while disallowing a fee-shifting bylaw channelled more litigation back to Delaware, determining the direction of multi-forum litigation); and Roberta Romano & Sarath Sanga, The Private Ordering Solution to Multiforum Shareholder Litigation, 14 Journal of Empirical Legal Studies 31 (2017) (empirically analyzes corporations that adopted exclusive forum provisions either in the charter or the bylaws). 16 Id. at 955. 17 Id. at 956. According to the court, “a corporation’s bylaws are part of an inherently flexible contract between the stockholders and the corporation under which the stockholders have powerful rights they can use to protect themselves if they do not want board-adopted forum selection bylaws to be part of the contract between themselves and the corporation.” Id. 18 According to the Boilermakers court, “[t]hus, even though a board may, as is the case here, be granted authority to adopt bylaws, stockholders can check that authority by repealing board-adopted bylaws. And, of course, because the DGCL gives stockholders an annual opportunity to elect directors, stockholders have a potent tool to discipline boards who refuse to accede to a stockholder vote repealing a forum selection clause. Thus, a corporation's bylaws are part of an inherently flexible contract between the stockholders and the corporation under which the stockholders have powerful rights they can use to protect themselves if they do not want board-adopted forum selection bylaws to be part of the contract between themselves and the corporation.” Boilermakers, supra note 15,at 956—957. The court does not mention the fact that the displeased shareholders would rather sell their shares and discontinue their relationship with the company rather than waging a costly fight to either amend the bylaw or elect a new set of directors. Especially for publicly traded corporations, such a robust “exit right” could substantially destroy an individual shareholder’s incentive to engage more actively with any corporation’s governance. See infra Part II for more detailed analysis. 19 Boilermakers, supra note 15,at 957. Under Delaware jurisprudence, bylaw amendments are subject to judicial scrutiny according to the degree that their purpose is determined “proper” and “equitable.” See infra Part I for more detailed analysis.


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The courts’ reasoning in ATP Tour and Boilermakers raises some interesting questions. Does the courts’ adoption of the contractarian principle, combined with the fact that shareholders grant directors the right to unilaterally amend bylaws, imply that there should be very little, if any, judicial check on directors’ ability to unilaterally amend bylaws? What if company ownership is dispersed and the shareholders can easily sell their shares rather than try to amend the bylaws or wage a proxy fight to remove the current directors? Should the court more actively monitor board-amended bylaws in that case? What if a controlling shareholder (possibly with more than 50% of the voting power) adopts a bylaw through a shareholder resolution? More fundamentally, to the extent that we apply the contractual framework to charters and bylaws, what can we learn from how modification is treated under contract law? What about its treatment of unilateral modifications? What similarities or differences can we learn by comparing bylaws and charters with contracts? Finally, as a policy matter, should the directors or the shareholders be able to unilaterally amend bylaws with little or no oversight from the courts?

This Article’s purpose is to shed light on these important issues. While the Article’s primary focus is on unilateral bylaw amendments, it also deals generally with the amendment of both charters and bylaws. Our analysis draws from both agency and contract law.20 Under agency law, when a principal and agent form a contract, like a retainer agreement between an attorney and a client, the court will determine the principal and agent’s rights and obligations under contract using contract law (and not necessarily fiduciary) principles.21 In that sense, the contractarian principle, that the charters and bylaws may be treated like a “contract,” is broadly consistent with agency law principles. On the other hand, when we look at contract law, we discover that amending a contract is subject to various statutory and judicial restrictions. Probably the most relevant contract doctrine applicable to charter and bylaw amendment is the duty of good faith and fair dealing.22 Contract modifications, including those that both parties voluntarily agreed to,

20 Coffee (1988) argued that we examine actual contract law to better understand a corporation’s opting out of default rules through charter amendments. According to Coffee, “the risk of [managerial] opportunism is greatest when the charter provision is added by an amendment that shareholders do not fully understand,” and to guard against such opportunistic amendment, we could look at contract law’s regulation of modification, including Restatement (Second) of Contracts §89 that requires modification to be “fair and equitable in view of circumstances not anticipated by the parties when the contract was made.” Id. at 938 – 939. We expand this approach to both charter and bylaw amendments and also, more specifically, to unilateral bylaw amendments. 21 See infra Part II-A for more detailed discussion. 22 Good faith duty under contract law should be distinguished from directors’ good faith obligations to the corporation under corporate law. See, e.g., DGCL §102(b)(7). There used to be some uncertainty in Delaware case law as to what directors’ good faith obligation entails and whether the obligation is separate from the other fiduciary duties of care and loyalty. Although, in theory, the courts could have harmonized the good faith obligation under corporate law with that under contract law, Delaware case law took a divergent approach by placing the good faith duty as part of the duty of loyalty. See Stone v. Ritter, 911 A.2d 362, 370 (Del. 2006) (stating that “although good faith may be described colloquially as part of a ‘triad’ of fiduciary duties that includes the duties of care and loyalty, the obligation to act in good faith does not establish an independent fiduciary duty that stands on the same footing as the duties of care and loyalty…[w]here directors fail to act in the face of a known duty to act, thereby demonstrating a conscious disregard for their responsibilities, they breach their duty of loyalty by failing to discharge that fiduciary obligation in good faith.”) See generally David Rosenberg, Making Sense of Good Faith in Delaware Corporate Fiduciary


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must be done in good faith or be fair and equitable.23 Even when a party exercises a contractually granted right to unilaterally modify the contract, as is often done in many consumer and commercial contracts, the party with the right to modify the contract must exercise it in good faith and must deal fairly with the counterparty. While different courts have constituted this duty with different elements, in the context of unilateral modifications, the most common requirements include the obligation (1) to disclose the proposed modification to the counterparty; (2) to grant the right to opt out of the proposed modification or terminate the contract; and (3) to not retroactively apply the modified provision.24

When we compare the rights of contracting parties with those of shareholders more broadly, we uncover several important factors that would make shareholders—particularly minority shareholders—more vulnerable than contracting parties. First, as other scholars note, even for charter (and bylaw) amendments that require express shareholder approval, for corporations with dispersed ownership, shareholders face collective action and rational apathy (or rational ignorance) problems.25 When such problems become severe, the shareholder approval process provides little meaningful protection for investors against managerial opportunism. On the opposite end, when ownership is concentrated, for instance with a controlling shareholder who has more than 50% of the voting power, the collective action and rational apathy problems for the shareholders as a class may be absent, yet minority shareholders (and possibly also the directors and the officers) may be

Law: A Contractarian Approach, 29 Delaware Journal of Corporate Law 491 (2004) on how Delaware courts have grappled with the “triad” fiduciary duties of care, loyalty, and good faith. 23 See Restatement (Second) of Contracts §89 and UCC §2-209. See generally, Allan Farnsworth, Contracts (2004) at §4.22. 24 See infra Part II.B. 25 Especially when a shareholder owns a diversified portfolio, consisting, possibly, of thousands of stock, and he/she can easily trade the shares on a national exchange, there would be very little incentive for the shareholder to engage with any specific company’s governance issues. This is the problem of rational apathy or ignorance. See Bebchuk (1989) (noting how voting shareholders have little incentive to be informed over charter amendment proposals, for instance, by studying the lengthy proxy material, and would remain uninformed or under-informed). See also Gordon (1989) (raising concerns over opportunistic mid-stream charter amendments due to collective action and other problems). Romano (1989) and Coffee (1989) have noted that shareholders’ rational apathy does not necessarily mean that they will blindly vote in favor of management proposals. The uninformed shareholders can, instead, vote against all management proposals (they can “just say no”) or vote in favor of management proposals only some of the time (i.e., using a mixed strategy in game theory parlance). If shareholders were to always vote against management proposals, there would be too much rigidity in charter provisions. An important advantage of unilaterally amending the bylaws is, of course, that it does not require a shareholder approval and, hence, does not have to deal with shareholders’ (inherent) skepticism. Although some have argued that the rise of institutional ownership, such as mutual and pension funds, has alleviated the collective action problem, the fact that the typical institutional shareholder will own a diversified portfolio, often consisting of thousands of stock, will likely prevent it from meaningfully engaging with any specific company or any specific issue. Institutional shareholders can turn to proxy advisory firms’ (such as ISS and Glass Lewis) recommendations on how to vote their shares, but the advisory firms have also received the criticism that they lack sufficient interest in the company to make company-specific, tailored recommendations. See generally Stephen Choi, Jill Fisch, and Marcel Kahan, The Power of Proxy Advisors: Myth or Reality?, 59 Emory Law Journal 869 (2010).


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harmed by the opportunism of the controlling shareholder.26 Even worse, minority shareholders have little or no meaningful way to remove controlling shareholders or keep their powers in check.

Second, although the shareholders’ right to receive amendment notification is relatively well-enforced under federal securities laws,27 unlike in the contract setting, shareholders, particularly for publicly traded corporations, do not have the right to truly terminate their relationship with the corporation. Shareholders can always sell their stock, but the shareholder-corporation relationship remains preserved through the sale and the sale does not harm the corporation—at least not directly or immediately.28 Third, the relationship between the directors and the shareholders, and between a controlling shareholder and the minority shareholders, is more vertical and hierarchical, based agency notions, rather than horizontal and arms-length, as in an ordinary contractual relationship. Fourth, and more generally, whenever one party has the right to re-adjust or modify the relationship there is the possible dangers of opportunism.

Building on these differences, with the lessons learned from contract law, we argue that there is a policy-based justification to be more vigilant against charter and bylaw amendments, and particularly against unilateral bylaw amendments either by the directors or the shareholders.29 The policy goal should be to preserve flexibility in amending bylaws and charters while policing directors and controlling shareholders opportunism. This Article considers various policy levers, including (1) optional redemption that allows a dissatisfied shareholder to sell the shares back to the company, (2) more robust disclosure to the shareholders (possibly before the amendment takes place), (3) more reliance on shareholder voting and approval, and (4) stronger judicial oversight. After considering the costs and benefits of each proposal, we suggest that the courts more vigorously apply the proper and equitable purpose or effect test under corporate law30 and, borrowing from

26 See Albert Choi, Concentrated Ownership and Long-Term Shareholder Value, forthcoming in Harvard Business Law Review (2018) for an overview of the recent rise of ownership concentration in the US, particularly with dual class stock, and the problems of possible abuse. 27 See infra Part III. Federal securities regulation requires an 8-K filing when a corporation’s bylaw has been amended; it must be filed within four business days of the amendment. 28 See infra Part III. A shareholder selling her stock is more akin to a contracting party assigning or delegating her right or obligation to a third party. The underlying contractual relationship is preserved. 29 The fact that the “contractual framework” is being applied to charters and bylaws does not mean that they should be literally treated as contracts subject to all doctrines of contract law. As a matter of fact, it is likely infeasible to apply all contract law doctrines to corporate organizational documents. See George Geis, Ex-Ante Corporate Governance, 41 Journal of Corporation Law 609 (2016) (arguing that corporate law should not “outsource the resolution of ex-ante governance problems to generalized principles of contract law”) and Lipton (2016) (noting the dangers of treating charters and bylaws as contracts since the directors will be able to adopt mandatory arbitration provisions which must be enforced under the Federal Arbitration Act). 30 See Frantz Mfg. Co. v. EAC Indus., 501 A.2d 401, 407 (Del. 1985) (stating that “bylaws must be reasonable in their application” and holding that bylaw amendments, which required unanimous approval for any board action, among others, done for the purpose of avoiding a majority shareholder’s disenfranchisement, are valid) and Schnell v. Chris-Craft Indus., Inc., 285 A.2d 437, 438—439 (Del. 1971) (holding that the directors’ amending the bylaws and advancing a shareholder meeting date “for the purpose of perpetuating itself in office…[and] for the purpose of obstructing the legitimate efforts of dissident stockholders in the exercise of their rights to undertake a proxy contest against management” is “inequitable”). Although both Schnell and


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contract law, apply the good faith and fair dealing obligations in the bylaw and charter amendment context.31 With stronger judicial oversight, we argue the flexibility benefits can be preserved while value-destroying hold-up and externality (by managers’ or the controlling shareholder’s exercise of discretion in “bad faith”) can be better deterred.

The Article is organized as follows. Part I briefly reviews the statutory requirements of charter and bylaw amendments and recent developments in case law, highlighting how the courts, especially those in Delaware, have become more disposed to apply the contractarian principle to charters and bylaws. Part II focuses on the treatment of modifications, and particularly change-of-terms clauses in contract law. While the courts have utilized various doctrines in imposing restrictions against the possible abuse of the contract modification right—such as unconscionability, illusory promise (indefiniteness), good faith and fair dealing, and different canons of construction—Part II focuses primarily on the duty of good faith and fair dealing and shows how the application of this principle has often led to the duty of disclosure combined with the right to terminate the contract (or opt out of the proposed amendment). Part III compares the contract law regime with the corporate law regime and highlights important differences that can make shareholders more vulnerable to hold-up and counterparty opportunism. Part IV shows how the courts can remedy the hold-up and opportunism problem by more vigorously applying the equitable or proper purpose test as well as the good faith and fair dealing obligations to unilateral bylaw amendments. The Article argues that applying both concepts as remedies not only advances the goal of preserving flexibility while policing opportunism (by the managers or the controlling shareholders), but it also harmonizes corporate law with principles laid out in both contract law and agency law. Part V concludes.

I. Corporate Contract and Its Amendment

The notion that a corporation’s charter and bylaws can be thought of as a “contract” dates back to the U.S. Supreme Court case of The Trustees of Dartmouth College v. Woodward.32 Chief Justice Marshall stated that the Dartmouth College charter qualified as a “contract [among] the donors, the trustees, and the [British Crown]” and therefore was

Franz Mfg. devised and applied the proper and equitable (or reasonable) test fairly vigorously, as we will argue in Part II, courts more recently seem to have stepped away from such vigorous application, if they applied the test at all. While the proper and equitable purpose or reasonableness test was devised by the earlier cases of Schnell and Frantz Mfg., courts recently have applied it with much less vigor, if at all. 31 While we are in favor of borrowing and applying the implied obligation of good faith and fair dealing as a rule of interpretation, we do not advocate the wholesale incorporation of other contract law doctrines, such as unconscionability, indefiniteness, mutual assent, and various rules on remedy. This is consistent with the agency law principles. See Restatement (Third) of Agency §8.07 cmt. b (stating that “contract law principles of general applicability govern whether such agreements are enforceable and how they are to be interpreted, among other questions.”). Coffee (1989) has made a similar argument in favor of judicial activism. According to Coffee, “judicial activism is the necessary complement to contractual freedom” and comparing a corporation to a long-term, relational contract, “the court’s role becomes that of preventing one party from exercising powers delegated to it for the mutual benefit of all shareholders for purely self-interested ends.” Id. at 1621. 32 17 U.S. 518 (1819).


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subject to the protection under the U.S. Constitution’s Contract Clause.33 Since this seminal case, both courts and scholars have espoused and extrapolated the contract notion of corporations..34 Most notably, Jensen and Meckling, building on Ronald Coase’s earlier work, argued that the corporation organization can be viewed as a “nexus of contract” and laid down a cornerstone for much of modern corporate law and finance scholarship.35 Based in part on this contractarian or nexus-of-contract theory, scholars have argued that corporate law should take a more enabling approach by minimizing the number of mandatory provisions and instead offer an optimal set of default (“off the rack”) terms, and 33 Id. at 643—644. US Constitution Article 1, Section 10 states: “No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.” (italics added). 34 See Lawson v. Household Finance Corp., 152 A 723 (Del. 1930) (stating that “since [Dartmouth College]…it has been generally recognized in this country that the charter of a corporation is a contract both between the corporation and the state and the corporation and its stockholders”), Elligwood v. Wolf’s Head Oil Refining Co., 38 A.2d 743, 747 (Del. 1944) (stating that “the rights of stockholders are contract rights and [the court should] look to the certificate of incorporation to ascertain what those rights are”), and Centaur Partners, IV v. National Intergroup, Inc., 582 A.2d 923, 928 (Del. 1990) (stating that “corporate charters and by-laws are contracts among the shareholders of a corporation and the general rules of contract interpretation are held to apply”). See also Hibbert v. Hollywood Park, Inc., 457 A.2d 339, 342—343 (Del. 1982) (applying the rules used to interpret “statutes, contracts, and other written instruments” to construe corporate charters and bylaws) and Berlin v. Emerald Partners, 552 A.2d 482, 488 (Del. 1989) (holding that contract interpretation rules apply when interpreting certificate of incorporation). 35 See Michael Jensen & William Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 Journal of Financial Economics 305 at 310 – 311 (1976) (stating that “most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals…the private corporation or firm is simply one form of legal fiction which serves as a nexus for contracting relationships”) (emphasis original). Jensen and Meckling make numerous inferences to Ronald Coase’s earlier work. See Ronald Coase, The Nature of the Firm, 4 Economica 386 (1937). Numerous scholars have analyzed the theory over the years. See, e.g., John Coffee, No Exit?: Opting Out, The Contractual Theory of the Corporation, and the Special Case of Remedies, 53 Brooklyn Law Review 919 (1988); John Coffee, The Mandatory/Enabling Balance in Corporate Law; An Essay on the Judicial Role, 89 Columbia Law Review 1618 (1989); Lucian Bebchuk, Limiting Contractual Freedom in Corporate Law: The Desirable Constraints on Charter Amendments, 102 Harvard Law Review 1820 (1989); Marcel Kahan & Michael Klausner, Standardization and Innovation in Corporate Contracting (or “The Economics of Boilerplate”), 83 Virginia Law Review 713 (1997); Henry Hansmann, Corporation and Contract, 6 American Law and Economics Review 1 (2006); James Cox, Corporate Law and the Limits of Private Ordering, 93 Washington University Law Review 257 (2015); Ann Lipton, Manufactured Consent: The Problem of Arbitration Clauses in Corporate Charters and Bylaws, 104 Georgetown Law Review 583 (2016); Jonathan Rohr, Corporate Governance, Collective Action and Contractual Freedom: Justifying Delaware’s New Restrictions on Private Ordering, forthcoming in Delaware Journal of Corporate Law (2017), and Michael Klausner, The “Corporate Contract” Today, in The Oxford Handbook of Corporate Governance and Law, edited by Jeffrey Gordon and Wolf-Georg Ringe (2018). The nexus of contract theory, while facially correct, is a bit misleading in the corporation and agency contexts. When two parties, e.g., a prospective client and a lawyer, enter into an agency relationship using a contract, obviously, the vertical relationship is based on and is created through a contract, but most of the post-formation issues, that are not expressly (or impliedly) dealt with in the contract, including amending the initial contract, can be subject of the agency law, rather than contract law, triggering additional obligations, such as fiduciary duty. One purpose of this Article is to deal with the issue of to what extent can an agent change the agency relationship when the right of modification is granted upon her in the initial agency contract. See Deborah DeMott, Forum-Selection Bylaws Refracted through an Agency Lens, 57 Arizona Law Review 269 (2015) on the application of the agency law principles to unilaterally adopted forum-selection bylaws.


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enforce parties’ arrangements of their affairs (“private ordering”) in charters and bylaws.36 The premise is that rather than the state interfering with individual corporation’s governance arrangements through one-size-fits-all mandatory terms, state law should instead allow each corporation to adopt its own optimal arrangements through private ordering.37 Perhaps due to the contractarian theory’s influence, corporate statutes—particularly Delaware statutes—require only a small number of provisions in the charter and leave the corporation with almost complete discretion with respect to the bylaws contents.38 Subpart A will describe how state corporate statutes allow shareholders and directors to amend charters and bylaws, focusing, in particular, on unilateral amendment of bylaws. Subpart B will describe the recent case law development with respect to unilateral bylaw amendments.

A. Charter and Bylaw Amendment under Corporate Statutes

Perhaps consistent with this “enabling” approach, the corporation, subject to a few restrictions, can subsequently amend charters and bylaws as the directors and the

36 See Frank Easterbrook & Daniel Fischel, The Corporate Contract, 89 Columbia Law Review 1416 (1989) (stating that the corporation is a complex set of explicit and implicit contracts, and corporate law enables the participants to select the optimal arrangement for the many different sets of risks and opportunities that are available in a large economy. No one set of terms will be best for all; hence the ‘enabling’ structure of corporate law”) and Roberta Romano, Answering the Wrong Question: The Tenuous Case for Mandatory Corporate Laws, 89 Columbia Law Review 1599 (1989) (arguing that mandatory corporate law cannot be easily justified). But see Jeffrey Gordon, The Mandatory Structure of Corporate Law, 89 Columbia Law Review 1549 (1989) (doubting that full contractual freedom in corporate law will lead to private wealth maximization and advocating for some mandatory rules). See also Coffee (1989), supra note 1, at 1621 (stating that the “stable mandatory core” of corporate law is the “institution of judicial oversight”). 37 In terms of ensuring that the agreed-upon arrangements would be “optimal,” scholars have invoked various market mechanisms, such as capital markets (firms with suboptimal governance arrangements would find it costlier to raise financing) and product market (inefficient firms will be driven out through product market competition). See, e.g., Frank Easterbrook & Daniel Fischel, The Corporate Contract, 89 Columbia Law Review 1416 (1989). 38 See, e.g., MBCA §§2.02 and 2.06; and DGCL §§102(a) and 109. At various sections, Delaware statute, for instance, expressly incorporates the phrase, “unless otherwise provided in the certificate of incorporation,” and allows the parties to opt out of the default terms. Even the directors’ managerial rights provision is subject to modifications in the charter. DGCL §141(a) states: “the business and affairs of every corporation organized under this chapter shall be managed by or under the direction of a board of directors, except as may be otherwise provided…in its certificate of incorporation.” With respect to the charter, the most important mandatory provision is the one on capital structure. Delaware law expressly allows certain provisions in the charter and some of these are almost always included in the charters of publicly traded corporations. They are: (1) liability limitation for the directors and officers under DGCL §102(b)(7); (2) granting the directors discretion to issue preferred stock (“blank check preferred provision”) under DGCL §102(a)(4); (3) right to amend bylaws under DGCL §109(a); and (4) the right to change the number of authorized shares without a class vote under DGCL §242(b)(2). This is not to say that the Delaware statute has fully embraced the contractarian theory. If we look outside the charter, there are various mandatory provisions, such as stockholders electing directors annually (§211(b)), stockholders have the right to vote by proxy (§212(b)), and not having more than three classes on the board (§141(d)). See Gordon (1989). With respect to the opting out hypothesis, Hansmann (2006) has argued that, due to various impediments, including draft (amending) costs and network externality, corporations are more likely to not opt out of default provisions and, instead, to “delegate” future amendments to state legislatures and courts. See also Kahan and Klausner (1997) (examining the network externality effects of corporate charter provisions).


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shareholders see fit.39 Both the Model Business Corporation Act and Delaware General Corporation Law, at least with respect to charters, mandate a set of procedures that must be satisfied when a corporation wants to execute an amendment.40 For instance, under DGCL §242, only the directors can make a proposal to amend the charter41 and, except for a small number of provisions, shareholders must expressly approve the proposal for the amendment to be effective.42 Furthermore, under the Delaware statute, if a proposed amendment falls under one of three special categories, the most important being that the amendment adversely affects a class (or series) of shares, then the affected class (or series) will get to vote on the amendment separately as a class.43 Finally, neither the directors nor the shareholders can unilaterally amend the charter.44

Amending bylaws is a different matter. The Model Business Corporation Act vests both the directors and the shareholders with the power to amend bylaws.45 MBCA §10.20(b) allows directors to amend the bylaws unless (1) the articles of incorporation reserve that power solely to the shareholders or (2) the shareholders amend the bylaw in question and stipulate in the bylaw that the directors cannot thereafter amend it.46 For Delaware corporations the right to amend bylaws belongs to the shareholders, but it can be granted to the directors through a provision in the charter.47 Delaware General Corporation Law §109(a) states that “the power to adopt, amend or repeal bylaws shall be in the stockholders entitled to vote…Notwithstanding the foregoing, any corporation may, in its certificate of incorporation, confer the power to adopt, amend or repeal bylaws upon the directors….”48 The statute does, impose two important restrictions on the directors’ power.

39 At minimum, charter provisions must be “lawful” and “proper to insert in an original certificate of incorporation filed at the time of the amendment.” See DGCL §242(a). The case law has also ruled that the charter and bylaw provisions must be consistent with public policy. 40 For a more detailed analysis of charter amendments, see Min (2018). 41 DGCL §242(b)(1) states that the corporation’s “board of directors shall adopt a resolution setting forth the amendment proposed, declaring its advisability, and either calling a special meeting of stockholders entitled to vote…or directing that the amendment proposed be considered at the next annual meeting of the stockholders.” Hence, DGCL §242 expressly endows the directors to make an amendment proposal while subjecting that proposal to shareholder approval. This is in contrast to procedures on bylaw amendment. 42 See DGCL §242. Charter amendment is considered to be a “fundamental” change to the corporation, thereby requiring shareholder approval. See also MBCA §10. 43 See DGCL §242(b)(2). The other two categories that require a class vote are: (1) changing the number of authorized shares and (2) changing the par value of the stock. With respect to changing the number of authorized stock, however, if the original charter or the charter amendment that created the stock so provides, all shareholders can vote as a single class. In addition to section 242, there is another way of amending the charter, through merger (“amendment through merger”). See DGCL §251(3). Unlike §242(b), however, §251(e) does not mandate a class vote even when a certain class is adversely affected. 44 See supra note 41. 45 See MBCA §10.20. 46 Id. 47 See DGCL §109(a). 48 Id. Amending bylaws is one of the few actions that the shareholders can initiate under Delaware law. Most of other “fundamental” changes to the corporation, such as charter amendment, merger, and sale of all or substantially all of the assets, expressly require a board resolution. See, e.g., DGCL §§242(b), 251(b), and 271(a). See Stephen Bainbridge, Who Can Amend Corporate Bylaws, Professor Bainbridge Blog (January 5, 2006) available at http://www.professorbainbridge.com/professorbainbridgecom/2006/01/who-can-amend-corporate-bylaws.html.


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First, it expressly preserves the shareholders’ right to amend bylaws, which, with certain limitations, allows them to repeal or amend board-adopted bylaws.49 Section 109(a) of the Delaware statute states that “[t]he fact that such power has been so conferred upon the directors…shall not divest the stockholders…of the power, nor limit their power to adopt, amend or repeal bylaws.”50 Second, the statute places substantive and hierarchical limitations on amending the bylaws. Section 109(b) states that “[t]he bylaws may contain any provision, not inconsistent with law or with the certificate of incorporation, relating to the business of the corporation, the conduct of its affairs, and its rights or power or the rights or power of its stockholders, directors, officers or employees.”51 Thus, the bylaw must be consistent with state law and the corporation’s charter and it must relate to the corporation’s “business” or “affairs” or the rights of various constituents.

It is doubtful, however, whether the two restrictions the statute imposes could provide meaningful protection for the shareholders in practice. With respect to the first limitation, while in theory deciding whether the directors should have the power to unilaterally amend the bylaws is up to the shareholders, in practice almost all large, publicly traded corporations incorporated in Delaware have a granting clause in their charters.52 This is not surprising. Perhaps directors should have the right to amend the bylaws, considering that most corporate charters do not contain detailed provisions relating to the corporation’s business or affairs, nor do they stipulate the rights of various investors and other constituents. Ultimately, the directors have the authority to manage the corporation’s business and affairs.53 Furthermore, given that amending the charter is time-consuming and costly, due largely to the obligation of convening a shareholders’ meeting, granting the directors such a right can better preserve flexibility for the corporation for unforeseen future contingencies and circumstances. Alternatively, this also creates a danger that the directors, as agents of the corporation and its shareholders, may abuse that discretion to the corporation and shareholder’s detriment. As a matter of theory, it is unclear how much discretion directors should be given and what types of procedural or substantive checks must be imposed.

49 Because Delaware law does not expressly stipulate that shareholders have the power to limit the board’s right to amend (or repeal) shareholder-adopted bylaws, some commentators have noted that this raises the possibility of “cycling amendments and counter-amendments.” Id. However, once the charter expressly grants directors the right to unilaterally amend bylaws, if shareholders were to try, through a provision in the bylaws, to prevent the board from amending or repealing shareholder-adopted bylaw, such a restriction would be inconsistent with the charter and likely invalid. See Hamermesh (1998). See also Airgas, Inc. v. Air Prods. & Chems., Inc., 8 A3d 1182 (Del. 2010) (invalidating a bylaw provision that advanced a shareholder meeting because it was inconsistent with the staggered board provision in the charter). There also are other legal and practical limitations. For instance, shareholders cannot adopt a bylaw that would interfere with the board’s ability to manage the affairs of the corporation under DGCL §141(a). See Lawrence Hamermesh, Corporate Democracy and Stockholder-Adopted By-Laws: Taking Back the Street?, 73 Tulane Law Review 409 (1998), Gordon Smith, Matthew Right & Marcus Hintze, Private Ordering and Shareholder Bylaws, 80 Fordham Law Review 125 (2011), and Fisch (2018). 50 Id. 51 See DGCL §109(b). 52 See Min (2018). 53 See DGCL §141(a).


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B. Recent Developments in Corporate Bylaws

Recently courts, especially in Delaware, have moved towards granting directors more freedom in unilaterally amending the bylaws. The idea that the bylaws, along with the charters, constitute a contract between the corporation and shareholders (and also among the shareholders) underlies this trend. Once the shareholders grant the directors the right to unilaterally amend the bylaws under DGCL §109(a), the directors can go ahead and exercise that right. Under this theory the shareholders have, at least implicitly, agreed to such unilateral changes by including the granting provision in the charter.54 If shareholders are displeased with such changes, they can either amend the charter and take the director’s right away or possibly unilaterally repeal or amend the bylaw provision the directors adopted. In theory, the shareholders have procedural mechanisms to protect their rights against potential abuse by the board. Perhaps these mechanisms require little or no judicial oversight: shareholders and directors should be able to privately order their affairs with minimal intervention from courts.55

Directors have been fairly active in deploying this power. Recently they have unilaterally amended bylaws to include: (1) advance notice provisions requiring shareholders to provide detailed information to the board about their upcoming proposals (including possible proxy fights) during a specified window before the shareholders meeting; (2) exclusive forum provisions requiring prospective plaintiff-shareholders to bring corporate law-based suit only in Delaware; (3) special shareholder meeting provisions that allow only a shareholder with substantial share ownership (often 5% or more) to call a special shareholders’ meeting; and (4) fee-shifting provisions that require non-prevailing shareholders to reimburse all the fees and expenses that the corporation and its directors have incurred in the dispute.56

1. Boilermakers and ATP Tour

Although it was initially uncertain whether the court would uphold the unilaterally adopted bylaws, Delaware courts have sided with the directors, particularly with respect to bylaws dealing with shareholder litigation. The Boilermakers Local 154 Retirement Fund v. Chevron Corp.57 case is exemplary. The directors of Chevron and FedEx adopted exclusive forum bylaws that required shareholders to initiate corporate law-based litigation only in Delaware.58 In relevant parts, the bylaw stated:

Unless the Corporation consents in writing to the selection of an alternative forum, the Court of Chancery of the State of Delaware shall be the sole and exclusive forum for (i) any derivative action or proceeding brought on behalf of the Corporation, (ii) any action asserting a claim of breach of

54 The Chancery Court in Boilermakers called this an “implied consent.” 73 A.2d at 955 – 956. 55 The idea that the shareholders and the directors should be able to privately order their affairs with minimal judicial intrusion seems to underlie the courts’ reasoning that upheld unilateral bylaw changes. 56 For an overview of recently contested bylaws, see Hamermesh (2014), Choi (2018) (Fee-Shifting), Min (2018), and Fisch (2018). 57 73 A.3d 934 (Del. Ch. 2013). 58 Id. at 934.


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fiduciary duty owed by any director, officer or other employee of the Corporation to the Corporation or the Corporation’s stockholders, (iii) any action asserting a claim arising pursuant to any provision of the Delaware General Corporation Law, or (iv) any action asserting a claim governed by the internal affairs doctrine. Any person or entity purchasing or otherwise acquiring any interest in shares of capital stock of the Corporation shall be deemed to have notice of and consented to the provisions of this [bylaw].59

Without the application of such a bylaw, shareholders presumably would be able to bring suit against the corporation or the directors (and officers) under the rules of civil procedure. Traditionally, plaintiffs brought such suits either in the state of incorporation or the state where the corporation’s headquarters is located, or both.60

When the shareholders challenged the exclusive forum bylaw, the Chancery Court upheld its facial validity.61 The court reasoned that “the bylaws constitute a binding part of the contract between a Delaware corporation and its stockholders, and the bylaw dealing with litigation forum is a proper subject matter under Delaware General Corporation Law §109(b).”62 The court stated that when the shareholders grant the directors the right to unilaterally amend the bylaws in the charter, they have “assented to a contractual framework established by the DGCL and the certificate of incorporation that explicitly recognizes that stockholders will be bound by bylaws adopted unilaterally by their boards,” and “[u]nder that clear contractual framework, the stockholders assent to not having to assent to board-adopted bylaws.”63 According to the court, in case the shareholders are displeased with a board-adopted bylaw, instead of filing a shareholder lawsuit they can either repeal or amend the board-adopted bylaw, or even remove the directors at the next shareholders’ meeting.64 This reasoning strongly implies that the dispute over board-adopted bylaws should be resolved in the boardroom rather than in the courtroom.

Furthermore, while mentioning that the bylaws should be “interpreted using contractual principles,”65 the court relied on a couple U.S. Supreme Court cases, The Bremen v. Zapata Off-shore Co.66 and Carnival Cruise Line v. Shute,67 which validated

59 Id. at 942. 60 See Choi (2018) (Fee-Shifting). 61 NEED CITE 62 Boilermakers, at 955. 63 Id. at 956. In an earlier case, the federal district court in California ruled that unilaterally adopted forum selection bylaw is invalid under the principles of contract law. Galaviz v. Berg, 763 F.Supp.2d 1170 (N.D. CA 2011). The court stated that: “under contract law, a party’s consent to a written agreement may serve as consent to all the terms therein, whether or not all of them were specifically negotiated or even read, but it does not follow that a contracting party may thereafter unilaterally add or modify contractual provisions.” Id. at 1174. The Boilermakers court criticized this reasoning, stating that the conclusion “rests on a failure to appreciate the contractual framework established by the DGCL for Delaware corporations and their stockholders.” Boilermakers, at 956. 64 Id. 65 Id. at 957. 66 407 U.S. 1, 92 S. Ct. 1907 (1972). 67 499 U.S. 585, 111 S. Ct. 1522 (1991).


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forum selection clauses. Citing Bremen, the Boilermakers court held that the forum selection clauses are valid so long as they are “unaffected by fraud, undue influence, or overweening bargaining power,” and that the provisions “should be enforced unless enforcement is shown by the resisting party to be ‘unreasonable.’”68 Hence, while the court did attempt to examine both the procedural and substantive aspects of the adoption of the forum selection bylaw, examining the issues of “fraud, undue influence, or overweening bargaining power” and whether the provision’s enforcement would be “unreasonable” would still leave directors plenty of latitude.69 In fact, in ATP Tour Inc. v. Deutscher Tennis Bund,70 the case that validated fee-shifting bylaws, there was little mention of whether the bylaws should be examined under the principles of contract even though the decision relied heavily on the contractarian principle.71 Taken together, Boilermakers and ATP Tour espoused the principle of minimal judicial interference when corporate directors exercise their charter-granted right to unilaterally amend bylaws.

2. Subsequent Developments

Buoyed by judicial endorsement, it is not surprising that corporate directors and practitioners began experimenting with other types of bylaws. In City of Providence v. First Citizens Bancshares, Inc.,72 the defendant-directors of a Delaware corporation adopted a forum selection bylaw that required shareholders to bring suit only in the state of the

68 Id. citing Bremen, 407 U.S. at 10. 69 The Boilermakers court states that: “the plaintiff may sue in her preferred forum and respond to the defendant’s motion to dismiss for improper venue by arguing that...the forum selection clause should not be respected because its application would be unreasonable. The plaintiff may also argue that…the forum selection clause should not be enforced because the bylaw was being used for improper purposes inconsistent with the directors’ fiduciary duties.” See 73 A.3d 934 at 958 (Del. Ch. 2013). The court also states that the bylaws are presumed to be valid and to successfully challenge the “facial statutory and contractual validity of the bylaws,” the plaintiffs must show that “the bylaws cannot operate lawfully or equitably under any circumstances.” (emphasis original). See 73 A.3d 934 at 948 (Del. Ch. 2013). The ATP Tour court similarly states that the fact that “under some circumstances, a bylaw might conflict with a statute, or operate unlawfully, is not a ground for finding it facially invalid.” 91 A.3d 554, 558 (Del. 2013). This line of analysis, however, is in tension with an earlier ruling by the Delaware Supreme Court. In CA, Inc. v. AFSCME Employees Pension Plan, the Delaware Supreme Court struck down a bylaw that would require reimbursement of proxy expenses (of the insurgent shareholders) by finding that complying with the bylaw will lead to a breach of directors’ fiduciary duties under “at least one…hypothetical.” 953 A.2d 227, 238 (Del. 2008). 70 91 A.3d 554 (Del. 2013). While the ATP Tour court does mention the requirement that the amendment must be done for a “proper” or “equitable” purpose (and effect), it does not delve more into the purpose behind the fee-shifting bylaws. According to the court, “the enforceability of a facially valid bylaw may turn on the circumstances surrounding its adoption and use,” but the certification from the US Third Circuit Court “dos not provide the stipulated facts necessary to determine whether the ATP bylaw was enacted for a proper purpose or properly applied.” See 91 A.3d 554, 559 (Del. 2014). The court nevertheless states that the “intent to deter [shareholder] litigation…is not invariably an improper purpose.” Id. at 560. 71 There are a few areas in which a bylaw amendment will be subject a heightened judicial scrutiny. If the directors were adopting a bylaw with an anti-takeover feature against a hostile takeover attempt, the bylaw amendment will likely be scrutinized under the Unocal proportionality standard. Also, if the directors are deemed to interfere with the shareholder franchise, the bylaw will be subject to the Blasius compelling justification test. 72 99 A.3d 229 (Del. Ch. 2014).


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corporate headquarters, North Carolina.73 The Delaware Chancery court, citing Boilermakers and relying on the contractarian principle, upheld the bylaw.74 At the same time, practitioners were also experimenting with the idea of adopting a mandatory arbitration bylaw with or without a class arbitration waiver.75 Commonwealth REIT, a publicly traded Maryland real estate investment trust, adopted and attempted to enforce a mandatory arbitration clause.76 The state circuit court in Maryland, citing Boilermakers, upheld its enforceability.77 On the fee-shifting front, encouraged by the ATP Tour holding, some commentators have even suggested corporations implementing “no pay” bylaws, which would prohibit defendant-corporations from paying plaintiff-attorney’s fees.78 Although we can only speculate, if the contractarian principle were to hold and apply as in Boilermarkers and ATP Tour, one could make a persuasive argument that a mandatory arbitration clause or a “no pay” clause should also be binding against the shareholders.79 After all, to the extent that the directors can validly require the shareholders to bring suit in a certain jurisdiction or impose litigation costs on plaintiff-shareholders, there could be little reason to disallow the directors from forcing the shareholders to arbitrate their claims or committing not to pay the plaintiff-shareholders’ litigation costs.

On the advance notice and other bylaws, some corporate directors have begun to test the contractarian principle’s limits by imposing extensive information and qualification requirements before a shareholder can either call a special meeting of shareholders or nominate a director.80 For instance, Allergan (known for its production and sale of botox) adopted a bylaw, putatively with shareholder approval, that required any shareholder that wants to call a special shareholder meeting to disclose all of its (along with its “associates” 73 (likely need an Id.) 74 (likely need an Id.) 75 See Claudia Allen, Bylaws Mandating Arbitration of Stockholder Disputes?, 39 Delaware Journal of Corporate Law 751 (2015) and Matthew Baltay, Exclusive Forum Bylaws Are Going Mainstream: What’s Next, Byclaws Eliminating Shareholder Class Actions?, Boston Bar Journal (2015). 76 Need Cite 77 Corvex Mgmt. LP v. Commonwealth REIT, 2013 Md. Cir. Ct. LEXIS 3 (2013). See also Del. County Emples. Ret. Fund v. Portnoy, 2014 U.S. Dist. LEXIS 40107 (2014) (dismissing plaintiffs’ challenge against the mandatory arbitration bylaw of Commonwealth REIT based on res judicata principles). 78 See Thompson Bayliss, “No Pay” Provisions: The Forgotten Middle Ground in The Fee-Shifting Debate, Harvard Law School Forum on Corporate Governance and Financial Regulation, June 1, 2015, and Sean Griffith, Private Ordering Post-Trulia: Why No Pay Provisions Can Fix the Deal Tax and Forum Selection Provisions Can’t (2017). Since a “no pay” bylaw does not shift the corporation’s expenses onto the plaintiff-stockholders, this would not be in violation of the Delaware statute prohibiting fee-shifting bylaws. Another possibility is to shift the fees onto the shareholder-plaintiff’s counsel or any third-party entity that aids the plaintiff-shareholder. The Delaware statute only prohibits making the shareholder responsible for the corporation’s fees. See DGCL §§109(b) and 102(b)(6). Although subsequent cases have attempted to impose corporation’s litigation expenses onto the shareholders, but conditioned it on other criteria, such as when suit was brought in violation of the company’s exclusive forum bylaw, given that the plaintiff-shareholders are responsible for the expenses, none seems to have succeeded. See, e.g., Solak v. Sarowitz, 2016 Del. Ch. LEXIS 194 (declaring that §109(b) prohibits any provision that shifts the expenses to the shareholders in litigation dealing with an internal corporate claim) (italics original). 79 We suspect that this (including disallowing mandatory arbitration) might have been one of the primary motivations behind the Delaware Legislature’s prohibition of fee-shifting provisions and requiring Delaware to be the exclusive forum. See §§109(b) (second sentence) and 115. See Skeel (2016), supra note 13. 80 Need to cite to authority


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and “affiliates”) trading history.81 On the director qualification issue, HopFed Bancorp, a banking corporation headquartered in Hopkinsville, Kentucky, through its bylaws, imposed a director qualification requirement that any director candidate cannot be associated with any entity that has been subject to any kind of investigation or consent order from a regulatory agency (including the SEC).82 The qualification requirement seemed to be surgically directed at Stilwell Associates LP, an activist hedge fund that was waging a proxy fight against the bank and about to nominate Joseph Stilwell, who had previously entered into a consent decree with the SEC.83 While it may have been possible for the court to strike down both of these bylaws for being unreasonable or unduly restrictive,84 both cases settled before the court could make a decision on their merits.85 Taken together, applying the contractarian principle to corporate charters and bylaws, Delaware courts have firmly been on the path of expanding the directors’ (and shareholders’) right to unilaterally adopt bylaws when such right is granted in charter.

II. Agency and Contract Law Implications on Corporate Contract

The adoption of the contractarian principle to a corporation’s charter and bylaws naturally leads us to think about how modification of such “contracts” would be dealt with under either agency law or contract law. To the extent that the relationship between the directors and the shareholders (and even between controlling shareholders and minority

81 See Steven Davidoff Solomon, Allergan-Valeant Fight Holds Lessons for All Corporate Shareholders, The New York Times, September 18, 2014. Allergan’s bylaws already required only the shareholders that own more than 25% of the outstanding stock could call a special shareholder’s meeting. See PS 1 Fund v. Allergan, Verified Complaint, August 22, 2014. Allergan’s argument that this bylaw was “approved” by the shareholders was that when Allergan was submitting a charter amendment proposal for shareholder approval, on August 8, 2014, the company also disclosed the bylaw amendment, which did not require a shareholder approval. See Allergan’s Answer to Plaintiff’s Complaint and Allergan Definitive Proxy on August 8, 2014. In terms of who can call a special meeting of shareholders, Delaware statute is quite open-ended. DGCL §211(d) only states that: “Special meetings of the stockholders may be called by the board of directors or by such person or persons as may be authorized by the certificate of incorporation or by the bylaws.” 82 Vince Sullivan, Investor Says Kentucky Bank Is Preventing Director Nominations, Law360, May 10, 2017. The debate over how much restrictions a Delaware corporation can impose on director candidates is magnified by the fact that, like the provision on special shareholder meetings, the statute is relatively silent on the issue. DGCL §141(b) only states that: “Directors need not be stockholders unless so required by the certificate of incorporation or the bylaws. The certificate of incorporation or bylaws may prescribe other qualifications for directors.” (italics added). The statute, therefore, seems to grant a wide latitude to the directors (and the shareholders) in imposing various qualification limitations on director-nominees. Another important issue is that the statute does not expressly stipulate who can make a director nomination. See Hamermesh (2014) supra note 1 for more detailed analysis. 83 Stillwell Associates LP, et al., v. HopFed Bancorp Inc., et al., case number 2017-0343 (Delaware Chancery Court). Stillwell Associates’ Verified Complaint (May 4, 2017). 84 For instance, in the Allergan case, Chancellor Bouchard called the information requirement “quite a horse-choker of a bylaw.” At the same time, the defense counsel was willing to defend the bylaw based on the argument that the Allergan shareholders approved its adoption. See supra note 81. 85 An important aspect about advance notice bylaws is that, because they deal with the shareholder franchise, for instance in terms of right to nominate directors, call special meeting, or adopt a written consent, they are likely be subject to an enhanced judicial scrutiny, notably under Blasius. See Blasius Industries Inc. v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988). This distinguishes them from other types of bylaws, including litigation bylaws, which do not necessarily interfere with the shareholder franchise.


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shareholders) invokes agency principles, one could examine the amendment issue using either fiduciary duty (such as duty of care and duty of loyalty, including the duty of good faith) or interpretation rules of contract law. Under contract law, modification generally raises at least two important issues: (1) whether the parties have assented to the modification (the manifestation of mutual assent requirement);86 and (2) whether a modification is fair and equitable or made in good faith.87 This Part first briefly discusses agency law’s treatment of principal-agent contract and then examines the unilateral modification problem through contract law in more detail.

A. Agency Law’s Treatment of Principal-Agent Contract

Once we determine that the charters and bylaws constitute a “contract” among the shareholders, directors, and the corporation, the preliminary issue that arises is whether courts should use the principles of contract law or those of fiduciary law to deal with the scope and content of such “contractual” obligations. For instance, in terms of interpreting the provisions of charters or bylaws, the directors (and the shareholders) could theoretically be subject to either the interpretation rules of contract law or to fiduciary duty principles. If contract law rules were to apply, the court will try to determine the parties “intent” using textual and extrinsic evidence and will not a priori interpret the language in one party’s (for instance the shareholder’s) favor. On the other hand, if we applied fiduciary obligations, unilateral bylaw amendments are most likely to receive business judgment rule protection unless enhanced judicial scrutiny, such as the entire fairness rule or the Unocal proportionality test, would apply.88

Although corporate law is unclear on this issue, to the extent that the principal and the agent have decided to stipulate each party’s rights and obligations using a contract and (implicitly) carve out fiduciary rules, it seems appropriate to deal with the scope and content of such contractual obligations using the principles of contract law rather than those of fiduciary law. In fact, this is the approach taken in agency law.89 According to §8.07 of Restatement (Third) of Agency titled Duty Created by Contract, “[a]n agent has a duty to act in accordance with the express and implied terms of any contract between the agent and the principal.”90 The official comment to the section goes on to state that “[a]lthough a contract is not necessary to create a relationship of agency, many agents and principals enter into agreements. Contract-law principles of general applicability govern whether

86 See DeMott (2015) and Lipton (2016) on the problems of constructing “consent” (or the manifestation of mutual assent) in the case of corporate charter and bylaw amendments. 87 Fair and equitable requirement is imposed by the Restatement while the Uniform Commercial Code uses the good faith approach. See Restatement (Second) of Contracts §89 and UCC §2-209. 88 With the business judgment rule protection, because the plaintiff-shareholders must show that the directors were “grossly negligent” when amending the bylaws, this seems more deferential to the directors’ decisions than the contractual duty of good faith and fair dealing. 89 See Restatement (Third) of Agency §§8.07 and 8.13. For cases that apply contract law principles to principal-agent contracts, see Estate of Vizenor ex rel. Vizenor v. Brown, 2014 N.D. 143 (ND 2014), National Plan Adm’rs, Inc. v. National Health Ins. Co., 235 S.W.3d 695 (Tex. 2007), ADA Solutions, Inc. v. Meadors, 98 S.Supp.3d 240 (D.Mass 2015); and U.S. v. Whitman, 904 F.Supp.2d 363 (S.D.N.Y. 2012). 90 Need Cite


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such agreements are enforceable and how they are to be interpreted, among other questions.”91 At the same time, given that the principal-agent relationship is operating in the background, and to the extent that the contract leaves gaps, it would seem more appropriate to deal with such gaps using fiduciary obligations rather than with the rules of contract interpretation.92

B. How Contract Law Deals with (Unilateral) Modification

Turning to contract law, granting directors (or the shareholders) the right to unilaterally amend bylaws is akin to giving one party to a contract the right to unilaterally amend (or modify) the contract.93 These are often called change-of-terms clauses, and such provisions are prevalent particularly in consumer and employment contracts including credit card agreements and end user license agreements (EULAs). They are also visible in agreements among commercially sophisticated entities, including the cases where one party has the right to determine the price or the quantity in a sales contract.94 In addition to the good faith and manifestation of mutual assent issues that apply broadly to all contract modifications, the change-of-terms clause raises other issues: (1) whether the right is so open-ended as to make the contract (or the promise) illusory or too indefinite; (2) whether the right grants too much power to one party so as to make the term unconscionable; (3) what the parties might have intended by granting one party to unilaterally modify the contract (the question of contractual intent); and (4) in case the right is exercised, whether the exercise is in good faith and the modifying party is dealing fairly with the counter party.95 This section will first briefly review these issues in turn and will show that by 91 See Restatement (Third) of Agency §8.07 official comment b. 92 Under contract law, courts will attempt to find the contractual rights and obligations from the express language of the contract rather than finding them through some open-ended obligations. The implied duty of good faith and fair dealing, therefore, is used more as an interpretation, rather than a gap-filling, tool. This is in contrast to how agency law operates: even when an express agency contract is completely silent, courts will impose fiduciary obligations on the agent. 93 An important difference is that under contract law, unless contract stipulates otherwise, no party is given the right to unilaterally modify the contract. By contrast, under corporate law, shareholders always have the right to unilaterally modify bylaws. Technically, there is also a difference between having a change-in-terms clause in a contract versus a right to unilaterally amend bylaws in the charter, since the relationship between the charter and the bylaws is hierarchical. We doubt, however, that these differences would matter much, unless the bylaw provision in question is in conflict with the charter. For instance, even if the statute would have allowed a granting clause to be contained in the shareholder-approved bylaws, rather than the charter, unless there is another provision in the charter with which it conflicts, it seems unlikely that the court would have come to a different conclusion. 94 The most common commercial agreements that allow one party to dictate the terms of the transaction are output and requirements contracts as well as open-price contracts, which allow either the buyer or the seller to determine, ex post, the quantity or price of the good to be produced. See Uniform Commercial Code §2-306 and 2-209. 95 There also is a question of whether there is mutual assent to the unilateral modification. This issue arises most often with respect to consumer contracts, when, for instance, the notification is sent through a bill stuffer. One reason why the courts often required a meaningful opt out (or termination) was to satisfy the mutual assent requirement. See generally Peter Alces & Michael Greenfield, They Can Do What!? Limitations on the Use of Change-of-Terms Clauses, 26 Georgia State University Law Review 1099 (2010); Oren Bar-Gill & Kevin Davis, Empty Promises, 84 Southern California Law Review 1 (2010) and David Horton, The Shadow Terms: Contract Procedure and Unilateral Amendments, 57 UCLA Law Review 605


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cobbling together different doctrinal frameworks under contract law courts have imposed a substantial restriction on how the contractually granted right can be exercised.

1. Illusory Promise and Indefiniteness

Under contract law, granting one contracting party too much flexibility can lead to a lack of commitment and a presence of commitment (a promissory element) is essential for there to be a contract.96 The unilateral right to amend a contract can raise an analogous problem.97 When the parties expressly subject the unilateral modification right with certain obligations, such as a duty to provide advance written notice to the counter party, on the other hand, courts have held that the right of unilateral modification is no longer illusory.98 For instance, with an advance notice provision, the party with the right to modify the contract no longer has an unfettered discretion and is committing to a certain course of action (i.e., showing commitment necessary to construct a promise).

In re Haliburton is informative.99 In the case, Brown & Root Energy Services, a Haliburton subsidiary, unilaterally adopted a Dispute Resolution Program subjecting its employees to binding arbitration in resolving all disputes.100 The company sent a notice of

(2010). The Articles ultimately argue for a statutory mechanism to deal with commercial entities arbitrarily modifying their contracts with consumers. See also Michael DeMichele & Richard Bales, Unilateral-Modification Provision in Employment Arbitration Agreements, 24 Hofstra Labor & Employment Law Journal 63 (2006). 96 Contract requires a promise and for there to be a promise, there has to be some sort of a “commitment” by the promisor. See Restatement (Second) of Contracts §§1 and 2. When there is no commitment and therefore, no promise, the contract also lacks consideration. Accordingly, some courts treat the illusory promise problem as a lack of consideration problem. See infra note 67. 97 See, e.g., Cheek v. United Healthcare of the Mid-Atlantic, Inc., 378 Md. 139 (2003) (finding a change-of-terms clause in an employee handbook illusory and declining to enforce an arbitration clause later added by the employer); Floss v. Ryan’s Family Steak House, Inc., 211 F.3d 306 (2000); and Dumais v. American Golf Corp., 299 F.3d 1216 (2002). 98 See Pearson’s Pharmacy, Inc. v. Express Scripts, Inc., 2009 U.S.Dist. LEXIS 100915 (2009) (the change-of-terms clause required Express Scripts to provide written notice of any modifications and to give the pharmacy an option to terminate the contract if they disagreed with the changes) and Morrison v. Circuit City Stores, Inc., 70 F.Supp.2d 815 (1999) (change-of-terms clause with an obligation to give advance notice and the right could be exercised only at certain times of the year). 99 In re Halliburton Co., 80 S.W.3d 566 (Texas 2002). Allowing consumers to have the chance to opt out by terminating the contract has been deemed to better satisfy the requirement of mutual assent to the proposed unilateral amendment. See Stiles v. Home Cable Concepts, 994 F.Supp. 1410 (1998). The non-retroactivity clause combined with notice provision is often called the “Halliburton savings clause.” See In re 24R, Inc., 324 S.W.3d 564 (explaining that the Halliburton court “held that because the [amended arbitration agreement] contained a ‘savings clause’—including a ten-day notice provision and a provision that any amendments would only apply prospectively—that prevented the employer from avoiding its promise, the arbitration agreement was not illusory”). See Nelson v. Watch House Int’l, LLC., 815 F.3d 190 (5th Cir. 2016) for a recent application of the Halliburton savings clause. In credit card contracts, federal law prohibits or substantially restricts retroactive application. See Alces & Greenfield (2010) at 1143 – 1144 (describing the Credit CARD Act prohibits retroactive changes in the annual percentage rate while giving the creditor limited permission to increase the rate applicable to existing balances when the consumer defaults by being late for more than 60 days). 100 Nee Cite


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the program to all the employees in November 1997.101 The notice also informed the employees that by continuing to work at the company they would be accepting the new program.102

Myers, the plaintiff, challenged the binding arbitration clause in court, arguing, among other things, that the employer’s initial employment promise illusory because the company retained the right to modify or discontinue (terminate) the program.103 The Texas Supreme Court, applying Texas contract law, held that the arbitration clause was valid.104 Particularly with respect to the illusory promise claim, the Court stated that:

[T]he Program also provided that “no amendment shall apply to a Dispute of which the Sponsor [Halliburton] had actual notice on the date of amendment.” As to termination, the plan stated that “termination shall not be effective until 10 days after reasonable notice of termination is given to Employees or as to Disputes which arose prior to the date of termination.” Therefore, Halliburton cannot avoid its promise to arbitrate by amending the provision or terminating it altogether.105

Thus the promise to arbitrate was no longer illusory when the employer committed to not modify or terminate program without a 10 day notice and also committed to non-retroactivity.

Even without any express obligation, courts in other circumstances have attempted to “solve” this issue by imposing certain (implied) obligations, such as the covenant of good faith and fair dealing.106 In certain areas of contract law, the duty of good faith and fair dealing is expressly required by statute.107 The primary example comes from the Uniform Commercial Code requirements on output, requirements, and open-price contracts,108 under which one of the parties has the right to set either the quantity or the price term. The Uniform Commercial Code imposes an obligation to set the price and quantity terms in good faith.109 Because the duty of good faith is an obligation (or a commitment), this also presumably solves the illusory promise problem. Once the duty is imposed, the party with the unilateral modification right can no longer impose any term

101 Id. 102 Need Cite 103 Need Cite 104 Need Cite 105 In re Haliburton, supra note 99 at 569—570. 106 See Fagerstrom v. Amazon.com, Inc., 141 F.Supp.3d 1051 (2015) (declaring that an arbitration agreement that contained a right of unilateral modification is not illusory because Amazon was bound by the duty of good faith “to act within the common purpose of the agreement and to the justified expectations of the customers”). 107 Need Cite supporting this 108 See UCC §2-306 for output and requirements contracts and §2-305 for open-price contracts. 109 Id.


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that it likes. For instance, if the modified term is unfair to the counter-party (or deals unfairly with the counter party), it will no longer be valid.110

2. Unconscionability

The unconscionability doctrine is another line of attack plaintiffs often use against the change-of-terms clauses. If a court finds a contract term unconscionable, the court can strike it from the contract, modify the term, or even declare the entire contract unenforceable.111 The change-of-terms clause can be subject to unconscionability analysis because one party is given a (much) more favorable deal to the possible detriment of the other. As is well known, to prevail on an unconscionability claim, the plaintiff must show that (1) the term is both procedurally and substantively unconscionable; and (2) the unconscionability was present at the time the term is made.112 Because the second prong requires a demonstration of unconscionability at the time of the term’s creation, some courts have applied the doctrine to resolve the question of whether the presence of a change-of-terms clause at the time of the contract’s initial formation would render the contract or the change-of-terms clause itself unconscionable.113 Others have taken a slightly different approach and have been willing to apply the test to the time of modification (and not the initial formation) and to the unilaterally modified term, rather than the change-of-terms clause itself.114 If this were so, the plaintiff must show that the modification (and not the initial formation of contract) was both procedurally and substantively unconscionable. With respect to the latter, the plaintiff must show that the modified term is unreasonably favorable to the modifying party. This is very much an open question, and the courts will likely grapple with whether the modified term will have an unreasonably favorable effect for the plaintiff. More importantly, the plaintiff will also have to show that the amendment process itself was procedurally unconscionable. In many ways, this inquiry is similar to whether the modification was done in good faith.115

3. Interpretation

110 The idea is similar to imposing the duty of best efforts on an agent in an exclusive agency contract. See Wood v. Lucy, Lady Duff-Gordon, 118 N.E. 214, 218 (N.Y. 1917). See infra section II.B.4 for more on the implied duty of good faith and fair dealing. 111 See Restatement (Second) of Contracts §208 and UCC §2-302. 112 Id. 113 See, e.g., Flemma v. Halliburton Energy Services, 2013-NMSC-022 (2013) (finding an employment contract that contained a change-of-terms clause unconscionable because it was unreasonably favorable to the company). But see Gillman v. Chase Manhattan Bank, 73 N.Y.2d 1 (1988) (finding that a change-of-terms clause in a credit card agreement is not unconscionable because the term was normal in the industry). 114 See Powertel, Inc. v. Bexley, 743 So. 2d 570 (1991) (stating that the exercise of change-of-terms clause by including an arbitration clause is unconscionable because the clause is added without a bargain, and the counterparty did not have an opt out option, creating an absence of meaningful choice). 115 There are a lot of similarities between the issue of procedural unconscionability and the duty of good faith and fair dealing. Procedural unconscionability principally asks the process question: did the party in question act in a procedurally fair manner with the counter party? The inquiry is quite similar to asking whether the party has satisfied the fair dealing obligation.


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Court can also raise the issues of interpretation and ex ante intent with respect to change-of-terms clauses. Basically, when one party grants the other the right to modify the contract, this can raise the question of ex ante intent, such as what degree of discretion did the contracting parties intend and whether the altered term falls within that expectation. Badie v. Bank of America illustrates this issue.116 The case dealt with credit card agreements between the plaintiff-consumers and Bank of America.117 The original agreement contained a change-of-terms clause which, in relevant parts, stated:

We May Change or Terminate Any Terms, Conditions, Services or Features of Your Account (Including increasing Your Finance Charges) at Any Time. We May Impose Any Change in Terms on Your Outstanding Balance, as Well as on Subsequent Transactions and Balances. We may also add new terms, conditions, services or features to your Account. To the extent required by law, we will notify you in advance of any change in terms by mailing a notice to you at your address as shown on our records.

Subsequent to opening the credit card accounts, Bank of America attempted to insert a mandatory arbitration clause into the agreement by mailing half-page bill stuffers to its customers.118

The Badie court determined that inserting the mandatory arbitration clause raised an issue of interpretation, in addition to other contract law issues like unconscionability and the implied duty of good faith and fair dealing.119 Bank of America argued that the change-of-terms provision authorized any modification, but the court disagreed. According to the court, the only “terms” actually included into the original agreement pertained to “percentage rates for purchases, various fees, the method of computing balance, and the grace period.”120 While the broadly worded change-of-terms clause supported the Bank’s interpretation (that they could subsequently add the mandatory arbitration clause), the court reasoned that the plaintiffs’ narrow interpretation that the original agreement terms did not include issues of dispute resolution. Between these two possible interpretations of the clause, the court ultimately determined that the plaintiffs’ more narrow interpretation was more reasonable, and therefore, the Bank could not unilaterally impose a mandatory arbitration clause.121

4. Implied Covenant of Good Faith and Fair Dealing

116 67 Cal. App. 4th 779 (Ct. App. CA 1998). 117 Id. 118 Id. at 785. 119 Id. at 798. 120 Id. at 799. 121 Id. at 800 – 802. According to the court, all the terms that are included in the original contract pertain to “matters that were integral to the bank/creditor relationship” and do not discuss other collateral matters, such as the method and forum for dispute resolution, thereby making the banks’ interpretation less reasonable.


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At a very general level, all contracts require the contracting parties to exercise good faith in both performance and enforcement of the contract.122 Furthermore, the application of good faith usually presumes that there is some discretionary component in the performance of contractual obligations. Based on these principles, the courts will occasionally say that a party has to exercise good faith with respect to the discretion granted under contract.123 This principle is applicable to the issue of unilateral modification because, at least when done expressly, one party is clearly given discretion with respect to modification. The precise contours of what exactly good faith obligation entails is not entirely clear, and there tends to be a substantial amount of overlap when the courts analyze the issue under the implied duty as opposed to other contract law doctrines like illusoriness and procedural unconscionability.

Notwithstanding the uncertainty and substantial amount of doctrinal overlap, at least with respect to unilateral modifications of contracts, case law suggests that the courts seem to require a different combination of (1) a notice provision which obligates the amending party to notify the counterparty about the proposed amendment several days prior and before the amendment becomes effective; (2) a termination or opt-out right, allowing the counterparty to terminate the agreement if she does not agree with the proposed amendment; and (3) a non-retroactive application provision promising not to apply the modified provision to any issues or claims that arose before the modification.124 If we were to apply all three prongs, the modifying party must, first, give advance notice to the counterparty; second, allow the counterparty to terminate the contractual relationship (or opt out of the proposed modification); and third, make sure that the modified term will not apply retroactively.

III. Change-of-Terms Clause vs. Right to Unilaterally Amend Bylaws

Under the current system, unilateral bylaw amendments are facially similar to unilateral contract modifications in a few procedural dimensions. First, with respect to notice, for publicly traded corporations125 which are subject to federal securities regulation,

122 Restatement (Second) of Contracts §205 states: “every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement.” Official comment a refers to the good faith definitions in the Uniform Commercial Code. UCC §1-201(19) defines “good faith” as “honesty in fact in the conduct or transaction concerned” and, with respect to merchants, UCC §2-103(1)(b) defines good faith to be “honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade.” The comment goes on to state that: “the phrase ‘good faith’ is used in a variety of contexts, and its meaning varies somewhat with the context.” 123 See generally Farnsworth Contracts (4d ed), 494 – 500. 124 See, e.g., Badie v. Bank of America, 67 Ca. App. 4th 779 (Cal. App. 1998) (applying the implied covenant of good faith and fair dealing principle to unilateral insertion of arbitration clause in credit card agreements); and In re Halliburton Co., 80 S.W.3d 566 (Texas 2002) (imposing opt out right and prohibiting retroactive application). There often is a substantial amount of overlap between the court’s analysis of other issues, such as illusory promise and unconscionability, and implied duty of good faith and fair dealing. 125 It is unclear what disclosure obligations there are with respect to privately held corporations. In Delaware, there is no statutory obligation to disclose bylaw amendments. Instead, presumably, such obligation is likely to be part of directors’ fiduciary obligation to the corporation and its shareholders. This is sometimes called the duty of candor.


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the directors have an obligation to notify shareholders of the charter and bylaw amendment through an 8-K filing.126 Because 8-K filings are public, the disclosure of bylaw amendment through 8-K is arguably more effective than contract modification disclosure through bill stuffers, as is often done in consumer contracts.127 Second, if shareholders find the bylaw amendment unattractive, they can terminate their relationship with the corporation by selling their stock. Presumably this termination right is strongest for public corporations whose stock is actively traded on a national exchange such as the New York Stock Exchange and NASDAQ. Third, while the case law is not entirely clear, it seems unlikely that the courts will allow directors to apply the amended bylaw retroactively against shareholders, probably as a matter of public policy.128

However, even with notification and termination rights, there are important differences which make shareholders’ rights substantially weaker. First, unlike contract modifications, notice of bylaw amendments, as required under federal securities laws, is ex post.129 By the time the notice is given to shareholders, the amendments have already taken place and are effective. Under federal securities regulation, there is no requirement for the directors to notify shareholders of bylaw amendment proposals before the amendments become effective.130 Second, as other scholars note in charter amendment settings,131 the presence of an actively trading market, combined with the ex post notification feature, imply that even if a shareholder were to terminate her relationship with the corporation by selling her shares, when the amended bylaw is unattractive for the shareholders, the share price would already be depressed by the time of sale. The damage is already done by the time the shareholder exercises her termination right.132

126 Securities and Exchange Act §13 requires firms subject to the federal securities laws to make filings, including periodic reports, with the SEC to keep investors up to date. General instructions to Form 8-K, as adopted by the SEC under the Exchange Act §13, require the reporting firm to file Form 8-K with the SEC. As one of the events that must be disclosed through an 8-K, Item 5.03(a) includes both charter and bylaw amendments. 127 See supra footnote 119 and surrounding text. 128 There is question over what retroactive application means. One possibility is by looking at the timing when the cause of action arose. For instance, if it arose before the company adopted an exclusive forum clause, shareholders should not be subject to the bylaw. This raises the issue of whether the presence of a cause of action creates a “vested right” for the (future) plaintiff. Another, somewhat narrower approach is to look at the time of (constructive) notice of the lawsuit. If, for instance, shareholders file the lawsuit or give notice to the company of their intention to do so before the bylaws are amended, the lawsuit will not be subject to the bylaw. This was the approach used in Halliburton. See supra note 99. 129 Under the 8-K instructions, firms must report certain events, including charter and bylaw amendments, within four business days after the occurrence of certain events. 130Id. 131 See Easterbrook (1989) and Bebchuk (1989). 132 There also is a countervailing element that makes the shareholder’s right, vis-à-vis that of a contracting party, more robust. If we assume that the stock price represents the present value of the future “surplus” (e.g., dividends) that the shareholders expect to receive, selling it to a third party allows the shareholder to capitalize the (reduced) surplus. By contrast, when a contracting party terminates the contract, ordinarily, the terminating party does not receive anything, unless stipulated otherwise in the contract, from the counterparty. Tradable stock makes it easier for the shareholder to “terminate” the relationship.


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Third, and most importantly, shareholders do not have a meaningful right to opt out or terminate the relationship. Foremost, given that charters and bylaws affect all shareholders, and given the importance of preserving homogeneity, granting individual shareholder (or even individual shares) the right to opt out of amendments would be practically (if not legally) impossible.133 With respect to the right to terminate, when a shareholder sells her shares after the bylaw amendment, the corporation does not incur a loss because the shareholder will be selling her shares to new investors rather than back to the corporation.134 By contrast, in a contract setting, when the counterparty terminates the contract either before or after the contract modification, the party that modifies the contract will lose the contractual surplus that the party was expecting to realize in the future. A shareholder selling her shares (through market trading) is akin to a contract party transferring her rights (either through delegation or assignment) to a third party rather than terminating the contract. In a market trading stock, the relationship between a corporation and a shareholder is preserved and only the identity of the shareholders changes. If we are serious about achieving symmetry, shareholders should be able to get their shares redeemed by the corporation. The fact that the corporation does not suffer a loss when a shareholder sells is important for deterrence and incentive reasons. In a contract setting, if a party thinking about modifying the contract is concerned about the other party possibly terminating the contract in response, the party will think twice before going through the modification. On the other hand, if there is no loss of contractual surplus, there could be very little deterrence against self-serving modification.

More generally, the relationship between directors and officers, on the one hand, and shareholders, on the other, is based on the notions of agency. The relationship is more vertical and hierarchical, rather than horizontal or arms-length like the relationship between two contracting parties.135 Applying the notions of agency law, we often think of the shareholders as the de facto or de jure principal and the directors and the managers as the

133 One way of giving differential rights to the shareholders is by creating different classes of stock (Common A, Common B, Preferred A, Preferred B, etc.) and tailoring each class’s rights. But, of course, within each class, the same charter and bylaw provisions apply. 134 This is true even when the proposed bylaw amendment destroys value and reduces the share price. By contrast, when a corporation is selling stock with undesirable bylaw provisions, presumably the price that the investors will be willing to pay will decrease, which, in turn, reduces the amount of proceeds that the corporation gets. Therefore, at least in theory, the concerns over opportunistic or self-serving bylaw or charter amendments are greater when done “mid-stream” (that is, after the corporation has already received the proceeds from sale) rather than at the initial (or secondary) public offering. See Coffee (1989) and Gordon (1989). At the same time, however, there is doubt as to whether the initial public offering, presumably through its pricing mechanism, can effectively prevent seemingly inefficient charter or bylaw provisions. See Robert Daines & Michael Klausner, Do IPO Charters Maximize Firm Value? Antitakeover Protection in IPOs, 17 Journal of Law, Economics, and Organization 83 (2001) (documenting how many firms adopt anti-takeover devices at the time of their initial public offering). 135 The relationship does not necessarily fit nicely into the classic agency definition in the sense that the directors and the officers are acting “on behalf of” the corporation and its shareholders but subject to the shareholders’ “control.” See Restatement (Third) of Agency §1.01 (defining agency as “fiduciary relationship that arises when one person (a ‘principal’) manifests assent to another person (an ‘agent’) that the agent shall act on the principal’s behalf and subject to the principal’s control, and the agent manifests assent or otherwise consents so to act).


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agent who can act on the corporation and shareholders’ behalf.136 This vertical relationship imposes the fiduciary duty on directors and officers, including the duty of care and the duty of loyalty. While directors and officers, as the agents, have the right to manage the business and the affairs of the corporation,137 they must do so in the corporation and shareholders’ best interest. When we take into account that these agents are in charge of managing operations (and the shareholders are prohibited from interfering138) and that the shareholders are the residual claimants of the corporation, it follows that allowing the directors and the officers to unilaterally change the governance structures can give rise to the dangers of externality and hold-up.139

IV. Policy Implications

What should be the policy objective with respect to charter and bylaw amendments, and, in particular, with respect to unilateral bylaw amendments? We do not argue that just because the courts have applied the contractarian framework to corporate charters and bylaws that we should literally treat them as contracts and subject them to contract law doctrines. At the same time, just as the courts are borrowing the contractual framework conception, we can also examine other contract law principles to better formulate corporate law’s approach to charters and bylaws. We also do not argue that unilaterally amended bylaws are always detrimental to the shareholders. Some directors and officers undoubtedly act in the corporations’ best interest and attempt to maximize shareholders’ returns. They presumably amend bylaws (or make charter or bylaw amendment proposals) that would enhance such interest. At the same time, it is likely not sensible to doubt that there are certain directors and officers whose objective is to maximize their own private benefits and entrench themselves in the office.140 Thus, the first policy objective should be screening: deter charter and bylaw amendments that are harmful to the corporation and detrimental to shareholders while allowing (and promoting) amendments that are beneficial to shareholders.

Furthermore, there is the issue of preserving flexibility. Presumably, one of the reasons why a corporation would want to amend its charter and bylaws (even unilaterally by directors or shareholders) is to make sure that the corporation can effectively respond

136 Id. Perhaps, this can justify why the breach of an agent’s obligation to the principal can justify stronger remedy, such as disgorgement and punitive damages, while breach of a contractual obligation ordinarily triggers expectation of damages and does not allow the victim to recover punitive damages. See Restatement (Third) of Agency §8.01 (allowing various remedies, including injunction, forfeiture, and rescissory damages). 137 See DGCL §141(a). 138 See Hamermesh (1998) on how bylaws interfering with the directors’ right to manage the corporation under DGCL §141(a) will be invalid. See also CA, Inc. v. AFSCME Employees Pension Plan, 953 A.2d 227 (Del. 2008) (conflict between proxy expense reimbursement bylaw with DGCL §141(a) and attendant fiduciary duties of the directors). 139 In economic theory, the principal-agent relationship represents a classic example of how one party’s (agent’s) actions directly affect, i.e., imposes externality on, another’s (principal’s) welfare. 140 The central rationale behind applying heightened judicial scrutiny in hostile takeover cases is based on the concerns about directors’ and officers’ entrenchment against the interest of shareholders. See Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985).


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to new, previously unforeseen circumstances and challenges. This is similar to the reason why contracting parties would either want to modify the contract even though contract performance has not been finished or would want to bestow the right to amend the contract to one of the parties.141 Particularly with respect to giving directors the right to unilaterally amend bylaws, because going through shareholder voting process is costly and time-consuming, maintaining flexibility can be an important goal. In reference to the aforementioned concerns over possible abuse and managerial opportunism, the policy objective should be to devise a mechanism that will preserve flexibility benefits while prohibiting value-destroying (and self-serving) amendments. In this Part, we proposed and discuss several different possibilities, such as giving the shareholders the right to ask for redemption, mandatory pre-amendment disclosure, more robust voting, and, finally, more active judicial oversight.

A. Optional Redemption

Assuming that giving each shareholder or each share an opt out right (so that the amended provision will not apply to the shareholder or the share) is not feasible, one possible mechanism we can consider is to give the shareholders a redemption right so that if they disagree with a proposed amendment, or if it were to affect them adversely,142 they can sell their shares back to the corporation at a redemption price.143 The redemption price can be set equal to the stock price prevailing before the amendment’s announcement to protect shareholders from suffering a loss.144 This would give the shareholders a bona fide termination right, a right comparable to that of contracting parties. Particularly with respect to bylaws that directors unilaterally adopt or charter amendments that directors and officers 141 Restatement (Second) of Contracts, for instance, require that the modification must be done “in view of circumstances not anticipated by the parties when the contract is made.” Restatement (Second) of Contracts §89(a). There is some uncertainty as to what “circumstances not anticipated by the parties when the contract is made” means and how strongly courts enforce that “requirement” to the extent that the courts adopt the Restatement’s approach. The Uniform Commercial Code, in contrast, does not impose this requirement. See UCC §2-209. 142 This would be similar to triggering a class voting right when a charter amendment would have an adverse effect on a class of stock. See supra note 43. 143 Stock issued by a Delaware corporation can be made redeemable at the option of the holder. See DGCL §151(b) (“any stock…may be made subject to redemption by the corporation at its option or at the option of the holders of such stock or upon the happening of a specified event…). In fact, in venture capital financing, redemption rights are often granted to preferred shareholders but the rights get triggered only when certain events, such as another round of financing or merger, take place. See National Venture Capital Association Charter. At the same time, DGCL §160 imposes statutory limits on the amount of redemption (“no corporation shall (1) purchase or redeem its own shares…when the capital of the corporation is impaired or when such purchase or redemption would case any impairment of capital of the corporation…). Capital is impaired if the funds used in the repurchase exceeds the amount of the corporation’s “surplus,” which is defined by DGCL §154 as the excess of net assets over the par value of the corporation’s issued stock. See SV Investment Partners, LLC v. ThoughtWorks, Inc., 37 A.3d 205, 210 (Del. 2011) (citing Klang v. Smith’s Food & Drug Ctrs., Inc., 702 A.2d 150, 153 (Del. 1997)). 144 Another possibility is to grant shareholders an appraisal remedy, under which dissenting shareholders can demand payment of the “fair value” of their shares. Under the MBCA, with respect to certain charter amendments, shareholders have such a right. See MBCA §13.02(a). However, if the shares are publicly traded, shareholders are no longer entitled to the remedy. See MBCA §13.02(b). This is commonly known as the “market out” exception.


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opportunistically implement, a de facto termination right can provide a stronger deterrence against the corporate agents. Just like in a contract termination scenario, the corporation will now suffer an actual loss when the value-reducing bylaws or charters are adopted, and the shareholders redeem the shares in response, compared to the case where the shareholders merely sell their shares to others.

However, the problem with this proposal is that the redemption right would potentially make corporate organization less stable and make the corporate form less attractive. There also is the challenge of setting the right redemption price. For instance, if the redemption price is set equal to the stock price prevailing before the amendment or before the proposal’s announcement, but the stock price subsequently goes down for unrelated reasons, the drop could lead to a potentially massive capital withdrawal and subsequent liquidity crisis. Given that one of the primary benefits of choosing a corporate form is the capital lock-in and organizational stability, granting shareholders a strong redemption right could substantially reduce that benefit. There also is an issue with the deterrence benefit. When redemption does occur, since the loss is borne directly by the corporation—and indirectly by the remaining, non-redeeming shareholders, and not personally by the directors—the size of the deterrence benefit may also be questionable.145

B. Mandatory Pre-Amendment Disclosure

Another possible mechanism is to strengthen the disclosure of the proposed amendment so that the necessary disclosure takes place before, rather than after, the amendment. Such a regime is already in place with respect to charter or bylaw amendments that require shareholder approval.146 Thus this proposal is more relevant for bylaw amendments that are done unilaterally by directors or a controlling shareholder.147 The idea is similar to the pre-modification disclosure in contracts.148 However, in the context of corporations, pre-amendment disclosure will often be ineffective, particularly when there is an active public market for the corporation’s stock. With respect to unilaterally amended bylaws, because the proposed bylaw amendment does not require shareholder approval and will certainly become effective in the near future, the stock price will incorporate that information when the proposal is announced.149 And, even if an existing stockholder were

145 To the extent that officers’ and (possibly) the directors’ compensation is tied to stock performance or the market valuation of the company, these corporate agents will also suffer, albeit partially, from any decrease in the stock price. 146 For instance, under federal securities laws, charter amendment proposals are contained in the proxy for the shareholders’ meeting. See Min (2018). Even without federal securities regulations, under corporate law, any amendment proposal requiring shareholder approval will have to be circulated to shareholders in advance. 147 For Delaware corporations, shareholders can take any action through a written consent, without holding a meeting and without prior notice. See DGCL §228. Hence, a controlling shareholder, with more than 50% of the voting power, can unilaterally amend the bylaws through a written consent, without notifying the directors or the minority shareholders. 148 See supra Part III.D. 149 If there is robust judicial oversight, pre-amendment disclosure can work in tandem with judicial oversight. Upon corporation’s disclosure of the proposed amendment, shareholders can bring suit to enjoin the corporation from implementing the amendment.


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to try to terminate her relationship with the corporation by selling her stock, it is already too late because by then the stock value has already decreased.150 Unless shareholders can stop the proposed amendment from becoming effective (e.g., by securing an injunction from a willing court, which will require stronger judicial oversight) the share price has already absorbed the amendment’s future effects, and the shareholders will suffer a loss.

C. Shareholder Voting and Approval

Another possibility is to rely more on the shareholder approval process. Similar to mandatory pre-amendment disclosure, this is not relevant for charter or bylaw amendments that already require shareholder approval and is applicable to unilateral bylaw amendments. Shareholder approval can take a few different forms. The first requires the directors to get the shareholders’ express approval (i.e., through voting or written consent) on any proposed bylaw amendment or when a proposed amendment would affect them adversely.151 If the shareholders are displeased with the proposed amendment, they can simply vote the proposal down. There are, at least, two problems with this form. Foremost, an ex post shareholder vote on all bylaw amendment proposals renders the granting of the right to (unilaterally) amend bylaws to the directors somewhat useless. It turns the bylaw amendment into something more like a charter amendment. Given that there is a distinction between charters and bylaws, and one of the goals of granting directors the right to unilaterally amend bylaws is to preserve flexibility, this proposal would undermine that objective.152 Furthermore, the proposal imposes a potential for substantial cost and delay. When the directors want to amend the bylaws, they will have to wait until the next shareholders’ meeting or convene a special shareholders’ meeting to make the amendment effective. For public corporations, given the cost of having to circulate a proxy under federal securities laws this proposal would impose an additional cost on the bylaw amendment process.

A second variation is to strengthen the shareholders’ right to undo or amend director-adopted bylaws. Under both the Model Business Corporation Act and Delaware General Corporation Law, regardless of whether shareholders grant directors the power to amend bylaws, the shareholders’ right to amend bylaws cannot be restricted.153 While this is possible, similar concerns arise as in shareholder voting. To modify or repeal the bylaw provision that directors adopted, shareholders will have to circulate a bylaw amendment 150 Even if the stock is not listed on a national exchange or actively traded, presumably, if an existing shareholder wants to sell her stock to a third party, the amount the third party would be willing to pay for would be lower due to the value-destroying amendment. 151 See supra note 43. 152 As a possible compromise, we could require only the “material” bylaw amendments be submitted to the stockholders for approval. Unless the question of “materiality” is answered through the statute, this can inject a substantial amount of uncertainty. 153 See MBCA §10.20(a) and DGCL §109(a). This, of course, is subject to various legal and practical restrictions. See Fisch (2018) on how the existing legal structure imposes limitations on shareholders’ power to amend bylaws, making shareholders’ right considerably weaker than that of the directors. What this proposal is advocating for is to broaden or strengthen the rights of shareholders to amend or repeal board-adopted bylaws. See also Smith, Wright & Hintz (2011) (advocating for giving more rights to the shareholders to adopt and amend bylaws).


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proposal, convene a meeting (most likely at an annual shareholder meeting for a large publicly traded corporation unless a block holder with sufficient ownership can call a special meeting), and secure a requisite affirmative vote to pass the proposal. This may be quite costly and time-consuming. Furthermore, when the directors’ right to amend bylaws is in place, one must wonder whether the directors will promptly undo the shareholders’ bylaw amendment. So far, there is no case law that directly deals with this issue.154

A third option is to leave the system as is and allow shareholders to hold directors accountable through the director election process. This is the solution the Boilermakers court155 suggests, where the court upheld a forum selection bylaw that the directors unilaterally adopted. Similar to the problem of requiring bylaw amendment proposals to be subject to a shareholder vote, this mechanism will also be costly and time-consuming. In fact, compared to the shareholder voting mechanism, this would be even more costly because the shareholders would likely have to engage in a contested election process.156 For a public company, in an uncontested election where there is no competing slate of director-nominees, just getting enough votes against the existing directors poses a difficult challenge.157 Even if the shareholders somehow manage to secure enough votes against the existing directors, because the board of directors usually reserves the right to fill any vacancies, when a director fails to receive sufficient vote to be re-elected158 the rest of the directors can appoint either the director-nominee who failed to receive the requisite affirmative votes or someone else who will be friendly to their cause. To prevent this problem, the shareholders will have to come up with a competing slate of nominees. Even if there is a block holder (e.g., a hedge fund or an active institutional shareholder) who may be willing to do this, the block holder would be required to wage a potentially costly proxy fight.159 If there is not a block holder, it is extremely unlikely that any shareholder would

154 See supra note – on this cycling and counter-amendment issue. Another problem of relying on shareholders’ repeal is that until repeal has been approved by shareholders, the undesired bylaw remains effective. In contrast, if shareholders were to challenge the validity of a bylaw in court, the court can promptly strike it down. 155 See supra Part I. 156 See Hamermesh (2014) supra note 1. 157 The difficulty of removing directors in an uncontested election is illustrated by the recent experience at Equifax. After the company suffered from a massive data breach where private, sensitive information of about 150 million US consumers were compromised, various institutions, including the Institutional Shareholder Services, Inc., an influential proxy advisory firm, called for a vote against the re-election of the directors, especially the directors who served on the technology committee and failed to adequately oversee the cybersecurity risk. Despite the campaign, in an uncontested election, all of the director-nominees got re-elected. See AnnaMaria Andriotis, Equifax Directors Win Re-Election, Despite Concerns about Breach, The Wall Street Journal, May 3, 2018. 158 See DGCL §223(a)(1). Citation needed on charters and bylaws that grant the right to fill vacancies to the directors. 159 The recent experience at P&G shows how difficult it may be to remove an existing director in a contested election even when there is an activist hedge fund that is willing to spend a substantial amount of resources in a proxy contest, particularly when a large fraction of the shares are owned by individual, “retail” investors. Trian Fund Management LP, led by an activist Nelson Petlz, waged a proxy fight to replace one director from P&G’s board. The costly proxy fight between P&G and Trian reportedly led to a combined estimated expenditure of $60 million. See David Benoit, P&G vs. Nelson Peltz: The Most-Expensive Shareholder War Ever, The Wall Street Journal, October 6, 2017. The final tally was vigorously contested and when the dust


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be willing to spend the resources to wage a proxy fight. Overall, using director elections to provide a necessary check on bylaw amendments may be a costly overkill.

Furthermore, under certain circumstances, shareholders may not have any more chance of holding their directors accountable. This is the case when a target corporation is about to be acquired by another corporation and the target directors decide to unilaterally amend the target corporation’s bylaws, for instance, by including an exclusive forum or advance notice bylaw.160 Given that the target corporation will disappear in the near future and all of its directors will resign, there will be no opportunity for the target shareholders to express their disapproval through director election. Although, in theory, they can express their discontent by voting down the merger proposal, when the proposal comes with a premium, voting against the merger proposal would be a risky proposition.

Finally, relying on the shareholder voting mechanism is particularly ineffective if a controlling shareholder or a block holder has adopted a bylaw. When a controlling shareholder, with more than 50% of the voting power, adopts a bylaw through shareholder vote or through written consent, unless the minority shareholders can challenge the bylaw in court, there is no meaningful way for them to repeal or amend it. Also, unlike director elections, there is simply no way for the minority shareholders to remove a controlling shareholder or force the controlling shareholder to divest her interest in the corporation. Even when there is no controlling shareholder with de facto and de jure control, when a bylaw amendment is initiated and supported by a large block-holder, such as an activist shareholder with a bloc ownership, public shareholders may face an uphill battle to repeal or amend the bylaw. Especially due to the recent rise of concentrated ownership, many with dual class stock structure, the concerns over controlling shareholders’ possible abuse of power have become more salient.161

D. Stronger Judicial Oversight

The final option we consider is to subject charter and bylaw amendments to stronger judicial oversight. This Article argues that given the relatively weak procedural protections given to the shareholders, such as the weak termination and notification rights, a fairly persuasive case can be made for stronger judicial oversight. Stronger judicial oversight can play an effective role, particularly in preserving flexibility while deterring directors’ and controlling shareholder’s opportunism. Even if any of the structural remedies, such as shareholder voting, has been implemented, active judicial oversight can play an important

finally settled, Trian managed to eke out a win by a margin of 0.0016% of the shares outstanding. See David Benoit and Sharon Terlep, Activist Peltz Narrowly Wins P&G Board Seat, New Count Shows, The Wall Street Journal, November 15, 2017. 160 It is not uncommon for the target corporation to amend its bylaw (to include, for instance, an exclusive forum clause) at the same time it announces the merger proposal. See, e.g., Time Warner’s 8-K exhibit 3-1 (bylaw amendment), filed on October 24, 2016, available at https://www.sec.gov/Archives/edgar/data/1105705/000095015716002366/ex3-1.htm. 161 See Albert Choi, Concentrated Ownership and Long-Term Shareholder Value, forthcoming in Harvard Business Law Review (2018) for a discussion over the recent rise of concentrated ownership in the U.S., especially using dual class stock.


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role in complementing the structural protection. This Part first discusses the existing corporate law doctrine of proper and equitable (reasonable) purpose test and then analyzes the idea of applying the good faith and fair dealing test, borrowed from contract law to charter and bylaw amendments. Lastly, this Part discusses the advantages of imposing stronger judicial oversight.

1. Proper and Equitable Purpose Test

Under the existing corporate law, courts have broad power to declare certain charter or bylaw provisions invalid or to decline to enforce them on a case-by-case basis.162 Existing case law, especially for bylaws, requires the amendments be done for proper or equitable purpose.163 If the director-initiated bylaw amendment is deemed improper, inequitable, or unreasonable, shareholders can challenge the bylaw in court. The court can either strike down the entire bylaw provision or deny it on a case-by-case basis. The proper or equitable purpose test has been in Delaware court’s arsenal for quite some time, particularly since the seminal cases of Schnell and Frantz Manufacturing.164 As noted earlier, Delaware courts have recently seemed to shy away from a robust application of the test, as evidenced by ATP Tour and Boilermakers.165 Stronger judicial oversight implies that the courts revive the proper and equitable purpose test to more closely examine the purpose and effect (and the reasonableness) of charter and bylaw amendments, especially those unilaterally adopted.

2. Borrowing from Contract Law Principles

We can also find some ideas from contract law. One approach is to utilize contract law’s various interpretation principles. As seen earlier, when construing a change-of-terms clause, courts will attempt to infer the parties’ ex ante intent to determine how wide or narrow the directors’ discretion is by examining various extrinsic evidence surrounding the time of contract formation (or when the change-of-terms clause was entered into).166 If necessary, the court adopts a narrower interpretive posture to minimize the potential abuse of discretion and prevent hold-up. Similar interpretation techniques can be applied to charters and bylaws. For instance, if the directors recommend, and shareholders approve, a certain provision, statements in the proxy or other extrinsic evidence (including how such terms were commercially perceived at the time) can be used to infer the parties’ intent.167 Such a technique can be useful in delineating the discretionary scope of the charter provision granting directors the right to unilaterally amend bylaws. Also, when an amended

162 See, e.g., Schnell v. Chris-Craft Industries, Inc., 285 A.2d 437 (Del. 1971). The Schnell court declared directors’ bylaw amendment invalid, stating that “inequitable action does nto become permissible simply because it is legally possible.” 163 See Choi (2018) (Fee-Shifting) and Folk on the DGCL §109.06. See also Schnell and Frantz Mfg. 164 Frantz Mfg. Co. v. EAC Indus., 501 A.2d 401 (Del. 1985). 165 See supra part II. 166 See supra part II.B.3. 167 See Centaur Partners, IV v. National Intergroup, Inc., 582 A2d 923 (Del. 1990) (using statements from the proxy to determine the meaning of the phrase “any similar provision contained in the By-Laws of the corporation”).


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provision is ambiguous, contract law interpretation techniques can be applied to minimize ambiguity. The interpretation principle of contra proferentem can be deployed to interpret the terms against the drafter and to protect the counterparty.168 By interpreting an ambiguous bylaw term against the directors or the controlling shareholder, who drafted the amendment, the court can better protect the (minority) shareholders from counter-party opportunism.

The court can also employ the implied duty of good faith and fair dealing to charter and bylaw amendments.169 If the court determines that the amendment is either substantively or procedurally unfair to shareholders (or for that matter to the directors or officers) or that it was done in bad faith, the court can declare the amendment invalid or unenforceable.170 As noted earlier, under contract law, good faith and fair dealing obligations are understood to include (1) pre-amendment notification; (2) the right to terminate or opt out; and (3) non-retroactive application of the modified terms.171 Foremost, a persuasive argument can be made that the unilaterally adopted bylaw provision should not be applied retroactively.172 Additionally, given that the disclosure right, especially for corporations with publicly-traded stock, is ineffective and the termination right is absent, a case can be made for more proactive judicial review over the substantive terms to test whether they are substantively unfair. This would be akin to strengthening the substantive prong in response to weak procedural protection, an approach that courts have often utilized in contract cases.173 (This Part would benefit if there were additional analysis building on the statement that “a case can be made” for more judicial review. What is that case? How should judges act if they do exercise more proactive review? Authors: This is done in the next part.)

3. Benefits of Stronger Judicial Oversight

168 See Restatement (Second) of Contracts §206. For cases in which the Delaware courts have applied the method in interpreting charters and bylaws, see, e.g., Kaiser Aluminum Corp. v. Matheson, 681 A.2d 392 (Del. 1996) (interpreting an ambiguous provision in the certificate of designation against the corporation and in favor of the preferred stockholders) and Aleynikov v. Goldman Sachs Group, Inc., C.A. No. 10636-VCL (Del. Ch. 2016) (stating that contra proferentem should apply to interpret the word “officer” contained in bylaws against the drafter-corporation). 169 The good faith and fair dealing obligations under contract law are different from the good faith obligation imposed under corporate law. Contract law-based good faith and fair dealing obligations can be imported not as part of the directors’ fiduciary duty but because the courts treat charters and bylaws as “contracts” between shareholders and the corporation. See also supra note 22. Also, while the “fair dealing” component seems to invoke the entire fairness test under corporate law, the application of the contract law-based good faith and fair dealing test should not be tantamount to applying the entire (intrinsic) fairness test under corporate law. As a starter, the burden of proof will remain on the plaintiff (rather than on the defendant under the entire fairness test) to show that the directors acted in “bad faith” or did not deal “fairly” when amending bylaws. 170 The test can be applied to the entire clause as a whole (to determine, for instance, its facial validity) or on the application of the clause on a case-by-case basis. 171 See supra Part II.B.4. 172 See supra note 81 (on “Halliburton” savings clause) and surrounding text. 173 See unconscionability cases mentioned in part III. Judicial review of the substance of the amended bylaw may be particularly important when a controlling shareholder amends the bylaws, through written consent, without notifying the other shareholders or the directors under DGCL §228.


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Compared to the (structural) mechanisms that rely on shareholder voting, the solution of stronger judicial oversight can be deployed without substantial cost or delay. When a shareholder (or a group of shareholders) wants to challenge a charter or a bylaw amendment, she will seek equitable relief to limit its application or undo the amendment. If the court is willing to entertain this argument, the court can decide the (facial) validity issue relatively quickly. This is advantageous because of its speed and low cost. Also, since the shareholders will likely bring the case in a derivative manner or as a direct class action with an attorney incentivized to receive compensation, the mechanism can minimize the collective action problems.174 Finally, Delaware courts would be quite capable of allowing value-enhancing amendments while preventing self-serving amendments, thus promoting flexibility through case-by-case resolution. (maybe add a line explaining why the Delaware courts are capable of making this call, is it just because of their corporate law expertise?)

The principles of equitable or proper purpose and good faith and fair dealing will apply equally to unilateral bylaw amendments by shareholders—not just directors. For public corporations with dispersed or passive institutional ownership, shareholders’ abusing their unilateral amendment power is quite unlikely. On the other hand, potential shareholder abuse (or opportunism) could be an important concern when a corporation has a controlling shareholder with over 50% of the voting power, or a shareholder with substantial block ownership, e.g., an activist institutional owner.175 In either case, a controlling shareholder or a block-holder can successfully amend the bylaws to either impede the directors’ and officers’ right to manage the corporation’s business and affairs or to undermine the rights of the minority (or passive) shareholders.176 If we were to keep 174 In most derivative actions, plaintiff’s attorneys will be entitled to receive compensation from the corporation so long as the outcome of the litigation, either through judgment or settlement, creates a “common fund” or produces a “substantial benefit” to the corporation (and the shareholders). Since nullifying a bylaw will not ordinarily create a common monetary fund, the court will have to declare that it produces a substantial benefit to the corporation (or to the shareholders). This substantial benefit test, properly applied, can also function as a screening mechanism against frivolous lawsuits. See Sean Griffith, Correcting Corporate Benefit: How to Fix Shareholder Litigation by Shifting the Doctrine on Fees, 56 Boston College Law Review 1 (2015) for more detailed analysis on substantial benefit and common fund doctrines. There are obviously dangers and costs to relying on or inducing more shareholder litigation. But when the courts become more vigilant with respect to whether a “substantial benefit” exists for the corporation and the shareholders, such costs can be more effectively controlled. Recent instances of shareholder litigation in mergers and acquisitions transaction is exemplary. See In re Trulia, Inc. Stockholder Litig., 129 A.3d 884 (Del. Ch. 2016). See also Albert Choi, Fee-Shifting and Shareholder Litigation, 104 Virginia Law Reviewm59 (2018) on how the Delaware legislature and the courts could allow symmetric fee-shifting system to encourage meritorious lawsuits while discouraging non-meritorious ones. 175 See Albert Choi, Concentrated Ownership and Long-Term Shareholder Value, forthcoming in Harvard Business Law Review (2018). 176 See Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442 (2011) (invalidating a reserve stock split bylaw amendment executed by the directors because it favored the controlling shareholder at the expense of minority shareholders); and Hollinger International, Inc. v. Black, 844 A.2d 1022 (Del. Ch. 2004) (invalidating bylaws enacted by a controlling shareholder that prevented the board “from acting on any matter of significance except by unanimous vote” and “set the board’s quorum requirement at 80%” because the bylaws “were clearly adopted for an inequitable purpose and have an inequitable effect.”). But see Frantz Manufacturing Co. v. EAC Industries, 501 A.2d 401 (Del. 1985) (validating bylaws adopted by a majority stockholder that increased the board quorum requirement and mandated that all board actions be unanimous. The court found that the amendments were “a permissible part of [the stockholder’s] attempt to avoid its


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the existing framework and preserve the fidelity to the contractarian principle with little judicial oversight, there may be very little that directors or minority shareholders can do to police controlling shareholders’ or block-holders’ abuse.177 Through stronger judicial oversight, we can restore the symmetry in deterring abuse by directors and officers on the one hand, and shareholders on the other.

Stronger judicial oversight can also apply to cases where shareholders have approved a proposed bylaw or charter amendment. Under contract law, even for a bilateral modification (a modification that both parties agree to), the court can still declare the modified provision unenforceable. The purpose, under contract law, is to prevent hold-up and abuse of bargaining power.178 In the context of charter or bylaw amendments putatively approved by shareholders, particularly when ownership is dispersed, the collective action and rational apathy problems can prevent shareholders from giving meaningful consent to the proposal.179 The problem may be more acute with respect to charter amendments, where the directors have the sole power to make an amendment proposal180 and in cases where there is a controlling shareholder or a block-holder. When the directors or the controlling shareholder (or the block-holder) are vested with the de facto power to set the agenda, knowing that the dispersed shareholders suffer from the collective action and rational apathy problems, can cause them to implement charter or bylaw provisions that

disenfranchisement as a majority stockholder” and, thus, were “not inequitable under the circumstances.”). Recently, National Amusements, Inc., a shareholder that has about 80% of the voting rights over CBS Corp. through ownership of high-vote shares, unilaterally amended CBS’s bylaws so as to require super-majority director approval for certain board actions, including declaration of in-kind dividend. This was in response to CBS directors’ threat of making pro rata stock distribution to all shareholders of CBS and to eliminate National Amusements’ voting control. Although the issue of whether National Amusements’ unilateral amendment is valid has not been resolved, the Delaware Chancery Court, citing Frantz Mfg., at least recognized a controlling shareholder’s right to protect its control position. CBS Corp. v. Nat’l Amusements, Inc., 2018 Del. Ch. LEXIS 157 (Del. Ch. 2018). 177 Especially due to the recent rise of dual class stock with concentrated ownership, this issue has become much more salient. Somewhat interestingly, courts have been more willing to apply the “equitable” or “proper” purpose test to controlling shareholders’ unilateral bylaw amendments. See Choi (2018) (Concentrated Ownership) (on the rise of dual class stock and concentrated ownership). These two lines of cases, one dealing with directors and the other dealing with controlling shareholders, have created a curious asymmetry in case law. One of the arguments of the Article is to harmonize these two lines of cases and also to import (or revive) the “good faith” and “fair dealing” principles. 178 See, e.g., Lingenfelder v. Wainwright Brewing Co., 103 Mo. 578 (1891) and Alaska Packers’ Assn. v. Domenico, 117 F. 99 (9th Cir. 1902). Before the adoption of “fair and equitable” test by the Restatement and the “good faith” test by the Uniform Commercial Code, courts used to apply the pre-existing duty rule to safeguard against hold-up and abuse of bargaining power, under which a modification for additional compensation for an existing promise would be held unenforceable. See generally Farnsworth (2004) §§4.21 and 4.22. 179 See Bebchuk (1989) (arguing that because the benefits accrue to all shareholders, individual shareholder will under-spend in investigating the likely effects of a charter amendment and this will lead to inaccurate pricing of an amendment proposal) and Min (2018) (how even institutional shareholders do not necessarily get informed and are incentivized to adopt the recommendations from proxy advisory firms). 180 See Min (2018) for examples of “opportunistic” or “preemptive” charter amendment proposals made by the directors and approved by the dispersed shareholders.


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are much more favorable to them at the expense of the (minority) shareholders.181 Such abuses can be deterred through more active judicial monitoring.

Stronger judicial oversight will not operate in vacuum: it will operate together with other policy tools, including director elections and shareholders amending or repealing board-adopted bylaws.182 To the extent that the shareholders do not have a meaningful termination right, nor an effective pre-amendment notification right, judicial oversight can become an effective check against directorial or controlling shareholder’s abuse of power. It will function as a complementary mechanism to the others. Particularly when the directors have the delegated power to amend bylaws, while preserving the flexibility benefits, judicial oversight can mitigate the externality and hold-up problems. Finally, because the judicial oversight mechanism taps into the existing corporate and contract law doctrines, it requires minimal change to the existing legal structure. The proper or equitable purpose test has been part of corporate law for a long time, and one could argue, this is also true of the good faith and fair dealing obligations.183 By restoring and applying these common law-based doctrines, not only will the contractarian principle be applied in its truest form, but corporate law doctrine can be harmonized with agency law principles.184 Conclusion

Over the past decade, courts have more willingly applied the theory that the corporate charters and bylaws constitute a contract between the shareholders and the corporations and have upheld a number of bylaw provisions that directors unilaterally adopted. This Article examined this contractarian principle by looking at the comparable issues under contract law. The Article highlighted the fact that the right to unilaterally amend bylaws under corporate law is similar to the change-of-terms clauses under contract law; and, under contract law, the exercise of such discretion is subject to various (statutory and common law) restrictions, including the obligation to act in good faith and deal fairly with the counterparty. Notwithstanding the similarity, when we compare the rights of contracting parties with those of shareholders, the rights of the shareholders are insufficient on one key dimension: the right to terminate the shareholder-corporation relationship. The lack of meaningful termination (or opt out) right, combined with the fact that the relationship between shareholders and directors (and minority shareholders and the controlling shareholder) is more hierarchical rather than horizontal, implies that the shareholders (or the minority shareholders) may be more vulnerable to managerial or controlling shareholders’ opportunism.

181 See In re Delphi Financial Group Shareholder Litigation, 2012 WL 729232 (Del. Ch. 2012) (controlling shareholder attempting to receive a control premium in a merger through a charter amendment by requiring the shareholders to simultaneously vote on the merger and the charter amendment). 182 One of us has argued how utilizing an open-ended standard can better allow contracting parties to police opportunism. See Albert Choi & George Triantis, Completing Contracts in the Shadow of Costly Verification, 37 Journal of Legal Studies 503 (2008). 183 See In re Delphi Financial Group Shareholder Litigation, 2012 WL 729232 (Del. Ch. 2012) (noting that a charter amendment is subject to the good faith and fair dealing obligations). 184 See supra Part II-A.


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In considering different mechanisms, the Article has argued that the policy goal should be to mitigate the problems of hold-up and opportunism while preserving the flexibility in amending corporation’s organizational documents. With that in mind, the Article has examined various mechanisms, including optional redemption, more robust disclosure rights, shareholder voting, and judicial oversight. After considering the possibilities, the Article suggests that stronger judicial oversight may be better able to achieve the policy goal. By more vigorously applying the proper and equitable purpose test, or by imposing the good faith and fair dealing obligations borrowed from contract law, the Article has argued that the court can better deter both directors’ and controlling shareholder’s opportunism and guard against collective action and rational apathy problems. At the same time, unlike other costly, time-consuming, or possibly ineffective mechanisms, because courts with expertise can deter opportunistic amendments more quickly and at lower cost, the flexibility desired for shareholders and managers in ordering their private affairs can be better preserved. (An additional final conclusion sentence wrapping up the main point will help this Part).

contractarian theory and unilateral bylaw amendments · 2018. 6. 29. · the mbca allows the...

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